Is the credit risk of high-yield bond funds worth the extra yield you’re getting now?
I recently met with a retired couple who had a portfolio that consisted of high-yield bond funds and dividend stocks. In the past, they had made money in real estate and decided to simplify their lives a few years ago and moved their profits into mutual funds.
After speaking with them and gauging their risk tolerance, it was clear that they were conservative investors and could not tolerate a short-term decline in account value of more than 10%.
They were surprised when I showed them what happened to these same funds during the last major market correction, before they had invested in them.
Are You Prepared to Hold Through a 30% Decline in Value?
Investors in recent years have understandably been challenged to find decent yields in a near-zero interest rate environment. But high yields can come at a high cost in the form of steep price declines in major market corrections.
Although the retired couple in my example had decent funds for generating income now, they had no idea of the market risk. For example, I showed them the performance history of their mutual funds and they were shocked that each of them, including the high-yield bond funds, had declined in value by at least 30% in the midst of the 2008 financial crisis.
In 2008, the average high-yield bond fund had a negative 26% return, whereas the Barclays Aggregate Bond Index had a gain of 5%. That’s a 31% differential!
Their stock funds fell in price by much more than 30%. Therefore the mutual funds, which were recommended by a local banker, may have been suitable for their investment objective, they were not suitable for their risk tolerance.
How Can You Get High Yields Without High Risk?
Put simply, if you don’t think you can hold on to your high-yield bond funds during a steep price decline, they may not be suitable for you because you can do significant harm to your portfolio if you sell at a low point.
Over the long term, high-yield bond funds have higher average yields and higher average total returns than bond funds that invest in higher credit quality corporate bonds and government bonds.
Therefore, you can get the high yields you want over time but you must be willing to hold on during the tough times.
If you are a conservative investor, you might try a more diversified approach. For example, if you need income, you might try investing in stocks or stock mutual funds with high yields but balance the market risk with bond funds with higher average credit quality, such as an index fund like Vanguard Total Bond Market Index (VBMFX), which now has a 30-day yield of 2.88% but it doesn’t have risk of price declines like high-yield bond funds.
An ETF that pays a bit more in yield without the extreme credit risk is iShares iBoxx $ Investment Grade Bond (NYSEArca: LQD).
The bottom line is that if you need income that is higher than the average rate of inflation, which is around 3%, you need to be willing to take on extra market risk. And the higher above 3% you need, the more market risk you’ll need to take, especially with regard to bond funds.
This article is brought to you courtesy of Kent Thune from Wyatt Research.