High Yield Bond Funds – Here’s What You Need to KnowJuly 6th, 2012 by David Waring
There are two types of high yield bond funds. Those that invest in municipal bonds and those that invest in corporate bonds. Both high yield municipal and corporate bond funds have two things in common.
- They are either rated below investment grade by the major credit rating agencies or carry no rating. In simple language, analysts believe that they carry a high risk of default.
- They pay yields that are higher than investment grade bonds. The market demands more yield to compensate for the additional risk.
Below is a list of the High Yield Bond Funds we rate here at Learn Bonds, and there is more information below the ratings table. For more on our rating criteria go here. See all the funds we rate here.
Our High Yield Bond Fund Ratings
|Fund Name||Active or Passive?||LB Rating||LB Rating Report|
|Delaware High-Yield Opportunities Fund (DHOIX)||Active||5 Stars||DHOIX Free Rating Report|
|Fidelity Capital and Income Fund (FAGIX)||Active||5 Stars||FAGIX LB Rating Report|
|Delaware National High Yield Municipal Bond Fund (DVHIX)||Active||5 Stars||DVHIX Rating Report|
|Lord Abbett Short Duration Income Fund (LDLFX)||Active||5 Stars||LDLFX LB Rating Report|
|DWS Floating Rate Fund (DFRPX)||Active||4 Stars||DFRPX LB Rating Report|
|iShares iBoxx $ High Yield Corporate Bond Fund (HYG)||Passive||4 Stars||HYG LB Rating Report|
|Templeton Global Bond Fund (TPINX)||Active||4 Stars||TPINX LB Rating Report|
|SPDR Barclays Capital High Yield Bnd ETF (JNK)||Passive||3 Stars||JNK LB Rating Report|
|PIMCO High Yield Fund D Class (PHYDX)||Active||3 Stars||PHYDX LB Rating Report|
|DoubleLine Emerging Markets Fixed Income Fund (DLENX)||Active||3 Stars||DLENX LB Rating|
When high yield bonds and high yield bond funds are discussed, it’s assumed that one is discussing high-yield corporate bonds, which is the focus of the rest of this article.
Historically, about 4% (by dollar value) on average of high yield bonds default. (The current rate is a little over 2%). Their relatively high default rate is why diversification is even more important when investing in high yield bond funds. This is also why if you are considering investing in high yield bonds we recommend investing in bond funds rather than buying individual bonds. High Yield bond funds will normally have less than 2% of the fund invested in any one issue, so if there is a default it is not likely to create a large loss for the fund.
Why are people attracted to high yield bond funds?
Yield! Yield! Yield! The big attraction of high-yield bonds funds is that they pay yields that are significantly higher than Treasury Bonds or Investment grade corporate bonds. Typically, high yield bonds pay 4 – 6% more yield than a treasury of a similar maturity.
Here are the current (July 2012) 12 month trailing yields of a typical fund in each of the below categories:
- High yield Funds, around 7%
- Intermediate bond funds around 3%
- Intermediate term government bond funds around 1.5%.
The spread or differences in yield between between high yield and other types of bonds changes over time. During the financial crisis in 2008 the yield on the average high yield bond briefly reached over 20%. Higher rated investment grade bonds on the other hand, only rose to around 10%. However, the previous year the difference in yields between high yield bonds and investment grade bonds was as low as 2%. While the yields offered by high yield bond funds look incredible compared to other bond fund categories, investors should be aware that when looked at in relation to the average yield on investment grade bonds (meaning as a spread over investment grade bonds), junk bond yields are currently in the middle part of their historical range.
What are the dangers of High Yield Bond Funds?
The biggest danger is that the bonds held by bond funds turn into “Junk”, worthless pieces of paper. In theory, as long as the losses due to defaults are less than yield differential between high-yield and other types of bond funds, high-yield junk bonds are a better investment. In essence, when an investor buys a high yield bond fund they are betting the extra yield will be greater than the extra-losses.
If the default rate of high yield bonds continues to be around 2%, junk bond funds should end up being a superior investment to government and broad market bond funds. A default rate of 5% would make junk bonds do poorly compared to the types of bond funds. However, it should be noted that the price of high yield bonds don’t move based on the actual default rate but predictions and fears of defaults.
What moves the price of high yield bond funds?
The yield on junk bonds has two components: Overall Interest rates & a credit spread. A credit spread is the amount of extra interest that a bond pays over US Treasuries, to compensate for the risk of default. While investment grade corporate bonds have a credit spread as well, a much smaller amount of their overall yield comes from the credit spread. With Junk bonds the majority of it yield (currently ¾ of their yield) comes from the credit spread. Unlike investment grade bonds where prices are primarily driven by changes in interest rates, the value of junk bonds is primarily driven by changes in their credit spread.
There is a close relationship between overall economic conditions, predictions of changes in default rates, and the actual default rate of high yield bonds. If economic conditions are getting better, defaults will decrease and the credit spread on bonds will compress. Conversely, worsening economic conditions will result in an increase in defaults and an expansion of the credit spread.
This has an interesting consequences to holders of high yield funds:
High yield bond funds don’t perform like other type of bond funds.
During times of economic expansion, interest rates tend to rise, causing most bond funds to lose value. While high yield bonds are negatively affected by rising interest rates as well, they are positively impacted by improving economic conditions. Because of this stock and high yield bonds have positively correlated performances. As overall economic conditions drive both the stock market and high yield bond funds, they tend to move together. As a result, some portfolio managers believe that investments in high yield bond funds believe that high yield bond funds should be considered “stocks” instead of “bonds” for purposes of asset allocation.