A high-yield bond sounds like a perfect investment combining gushing income with solid reliability.
But if you owned high-yield bonds in March, when their value sank on pandemic fears, you got a rude reminder that, in times of stress and panic, these bonds can skitter and dive like stocks.
In the first quarter, high-yield bond funds tracked by Morningstar declined an average of 12.7 percent. They’ve since partly recovered and are down 3.9 percent year to date.
The March downturn was an acute version of the volatility that periodically afflicts the sector. “Once every five to seven years, the high-yield market goes through an intense meltdown,” said Mark J. Vaselkiv, chief investment officer for fixed income at T. Rowe Price.
The meltdowns often coincide with economic slowdowns, when some companies that have issued high-yield — also known as junk — bonds can no longer pay their bills. Some even go bankrupt.
Yet if you can tolerate the ups and downs, a high-yield mutual fund or E.T.F. may serve a useful purpose in your portfolio. Over the longer term, such an investment can provide less-volatile returns than stock funds and better income than other bond funds.
High-yield bonds became synonymous with junk in the ’80s, when they were linked to a frenzy of debt-funded hostile takeovers, insider trading and the eventual imprisonment of the financier Michael R. Milken. More recently, the sector has been notorious for financing leveraged buyouts and speculative energy plays.
But today its biggest borrowers also include such household names as Ford Motor, Kraft Heinz and Netflix.
High-yield bonds are much riskier than Treasuries and, to a lesser degree, investment-grade corporate securities. But a fund or E.T.F. that invests in a broad array of them can enhance a diversified basket of investments, said Brian Moriarty, associate director for fixed income strategies at Morningstar.
“High-yield sits right in the middle and smooths your returns while increasing your yield,” he said.
But a high-yield fund shouldn’t account for more than 10 percent of someone’s portfolio — even that percentage would be high for cautious folk, Mr. Moriarty said. And because they don’t provide the protection in a severe downturn that Treasuries do, it may make sense to consider them, for allocation purposes, as part of your stock, rather than bond, basket.
Bonds are classified according to the ratings they receive from credit-rating agencies like Standard & Poor’s and Moody’s Investors Service. Better-rated, less-risky ones are termed investment grade, while lower-rated, riskier ones are high yield. The latter often have paid interest rates ranging from 6 percent to 10 percent, though in the current low interest-rate world, yields are generally lower: The Vanguard High-Yield Corporate fund’s yield is less than 5 percent.
High-yield bonds’ total return — their yield plus increases in their price — has made them a better performer than stocks over the last 20 years. From 2000 through the end of April, they provided a 6.5 percent annualized total return, compared with 5.4 percent for the S&P 500.
Over other periods, stocks have usually done better, though their returns have also zigzagged more. Andrew R. Jessop, manager of the PIMCO High-Yield Fund, said high-yield bonds typically deliver “half the return of equities with half the volatility.”
This year, high-yield bonds, like so many other assets, were shaken by the coronavirus. The iShares iBoxx High-Yield Corporate Bond E.T.F., a passively managed E.T.F. tracking a board-market index, sank in mid-March, only to rebound later that month and in April. The fund lost 5.36 percent year to date through the end of June. But for the 10 years that ended in June, it returned an annualized average of 5.6 percent. Its yield is a little over 5 percent.
The Federal Reserve’s announcement of programs to shore up corporate borrowing accounted for much of the rebound in corporate bonds of all sorts. “The Fed has been loud and clear in saying, ‘We are going to support the corporate credit markets,” said Elaine M. Stokes, one of the managers of the Loomis Sayles Bond Fund. The central bank even said it would buy shares of E.T.F.s that include some junk bonds.
The current recession is likely to drag some corporate borrowers’ credit ratings from investment grade to high yield. With the very low interest rates of the last several years, many companies doubled down on debt, said David Delbos, a co-manager of the BlackRock High-Yield Bond Fund.
As sales shrink, some are running into trouble. “In a period of economic weakness, you no longer have the same cushion,” he said.
Companies that drop from investment grade to high yield are known as “fallen angels,” said Karen Schenone, head of iShares fixed income strategy for BlackRock. They can give high-yield fund managers an opportunity to pick up solid companies facing what may be temporary setbacks.
“Ford’s an example of this,” she said. “They’ve been a fallen angel and rising star a couple of times.” Ford Motor was downgraded again at the end of March.
BlackRock offers a passively managed E.T.F. that invests in such companies — the iShares Fallen Angels U.S.D. Bond E.T.F. Other passively managed E.T.F.s investing in high yield include the iShares Broad U.S.D. High-Yield Corporate Bond E.T.F. and the Invesco Fundamental High-Yield Corporate Bond E.T.F.
The Vanguard High-Yield Corporate Fund, managed by Michael L. Hong, is an actively managed fund that leans conservative, favoring higher-rated bonds, which have a lower default rate than those at the bottom of the high-yield tier, especially during downturns like the current one. “You have this repeated cycle of complacency and greed and then a washing out at bottom,” he said.
Mr. Hong has run the Vanguard fund, which has an expense ratio of 0.23 percent, since 2008. Over the three years that ended June 30, Mr. Hong’s fund has returned an annualized 3.57 percent, compared with 3.19 percent for its Morningstar peer group.
Bill Zox and John McClain, co-managers of the Diamond Hill High-Yield Fund, make more concentrated bets than Mr. Hong does.
At the end of June, their heftiest holding, Cimpress, an Irish custom company, accounted for nearly 2.6 percent of their fund’s assets, while Mr. Hong’s largest, Sprint, was only 1.2 percent. Likewise, their top 10 holdings accounted for 22 percent of their fund’s assets, compared with 9 percent for Mr. Hong’s.
They stray from peers in other ways, too. Lately, they have parked about one-third of their fund’s assets in investment-grade securities. Mr. Zox said that when markets were sinking in March, they saw opportunities there for “equity-like upside with minimal credit risk.”
Their fund, whose A shares have an expense ratio of 0.96 percent, has returned an annualized average of 6.4 percent over the last three years.
As companies grapple with the fallout from the recession, bankruptcies are mounting. Mr. Vaselkiv, of T. Rowe Price, predicts an increase in high-yield-bond defaults.
“There’s a lot of large American companies in a world of hurt today,” he said. “The quality of the high-yield companies today is much better than 10 years ago, but not every company will make it.”