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"Portfolio Diversification-Junk Bonds"

© Naeem Akhtar

High-yield bond funds invest primarily in non-investment-grade bonds (those with a quality rating below BBB as rated by Standard & Poor's or Baa by Moody's) that provide substantially higher interest payments than investment-grade corporate bonds. Also called junk bonds, they are issued by companies with less than blue-chip financial security that may need a strong economy in order to prosper.

As a result, investors should use high-yield funds only as a part of a balanced portfolio because they entail a special risk. If the economy sags, the funds pay a severe penalty as prices plunge on the bonds they own. In fact, high-yield funds can experience price declines merely on the possibility of an economic slump.

For example, in the late summer and early fall of 1998, prices of high-yield bonds fell dramatically because investors feared that troubles in Russia would send the U.S. economy into a recession. The recession didn't happen, but the typical high-yield bond fund lost 10% of its asset value during the three months ended October 30, even though investment-grade bond funds advanced 2% during the same period.

During the shallow recession of 1990-91, another risk came to light. More than 10% of high-yield bonds defaulted on interest payments. Over the past 20 years, the default rate on high-yield bonds has averaged a much less terrible (but still serious) 2.8% a year. Hence the derisive "junk" moniker and bad-boy reputation.

But owning high-yield bonds for the long term has clearly been a winning strategy during the past two decades. Aided by yields averaging about five percentage points higher than comparable U.S. Treasuries, junk funds delivered higher total returns than their investment-grade counterparts over the past three-, five-, ten-, 15- and 20-year periods. While default remains a risk, the diversification that comes with a fund's portfolio (the average high-yield fund has 193 bond holdings) acts as a buffer against it. Since high-yield bonds pay higher coupons and benefit from the same economic factors that boost interest rates, they are less vulnerable to rising interest rates than longer-term, higher-quality bonds.

Even though 1998 was a poor year for high-yield funds, it provided a textbook example of how they move independently of both investment-grade bonds and stocks. That makes them an ideal diversifying tool in a long-term, income-oriented investor's portfolio because the door swings both ways: In six of the past eight years, the returns on high-yield funds surpassed investment-grade funds, and high-yield funds are trouncing investment-grade funds so far this year.