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It's not exactly a secret that investors in search of income have been struggling lately. With interest rates at record lows, trying to squeeze some extra yield out of interest-bearing investments has been a blood-from-stone proposition. That's one reason why dividend-producing stocks have become so popular recently -- folks have gotten fed up with paltry bond yields and moved into dividend stocks in the hopes that they can make up some lost ground. Unfortunately, stocks are not bonds and they carry a much greater risk of principal loss, so investors who see dividend-paying stocks and bonds as equal substitutes may be in for a rude awakening. Fortunately, yield-hungry investors have another option -- high-yield, or "junk" bonds.
Please sir, may I have some more yield?
In the wake of the financial crisis, the usual "flight to quality" ensued. Panicked investors rushed into U.S. Treasuries, thought to be one of the safest investments around. Yield spreads widened as investors rushed away from riskier debt, leading to large losses in the junk bond sector. However, as panic subsided and the economy stabilized, lower-quality bonds staged a rally. In fact, the Barclays Capital High-Yield Bond Index posted a 58.2% gain in 2009, and over the past three-year period, the index has produced an impressive 19.7% return on an annualized basis.
Investors have taken notice of junk bonds' stand-out performance, directing billions of dollars into the sector. In fact, Vanguard just announced that it's closing its Vanguard High-Yield Corporate Bond Fund (VWEHX) to new investments because of the massive inflows the fund has seen in recent weeks. Vanguard stated that the fund saw $2 billion in net inflows in the past six months alone. While that's one less option available to folks looking for a solid high-yield fund, there are still a handful of decent choices still willing to take investors' money.
Two solid options for broad domestic high-yield bond coverage are SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK ) or the iShares iBoxx High Yield Corporate Bond Fund (NYSE: HYG ) . The SPDR's portfolio consists of roughly 225 non-investment-grade taxable corporate bonds. The fund sports a 7.3% trailing 12-month yield and a 0.40% expense ratio. If you want just a little bit more diversification, the iShares fund invests in roughly 580 junk bond issues and carries a yield of 7.3% and a price tag of 0.50%.
Investors who want to delve into the popular municipal bond sector might want to consider a high-yield muni bond fund like Market Vectors High-Yield Muni ETF (NYSE: HYD ) . This low-turnover fund offers exposure to more than 200 higher-yielding municipal bonds from across the country. The fund's yield stands at 5.4%, and it will only cost you 0.35% to get in the door here. Just remember that you should never own a municipal bond fund in a tax-advantaged account like a 401(k) because you would lose the tax-exempt features of these bonds.
Lastly, if you're willing to take on even more risk in the high-yield arena, there are a few new ETFs that focus on high-yield bonds around the globe. The iShares Global High-Yield Corporate Bond ETF (NYSE: GHYG ) , which was just launched last month, offers exposure to high-yield corporate bonds from the U.S. and from developed markets around the world. Similarly, the newly created Market Vectors International High-Yield Bond ETF (NYSE: IHY ) offers a portfolio with much less emphasis on the U.S. market and more focus on both developed and emerging foreign countries. The iShares fund charges 0.55% in expenses, while the Market Vectors fund comes with a 0.40% price tag. However, both funds are very new and don't have a lot in the way of assets just yet, so investors may want to wait until they gather a little more mass so there aren't any liquidity issues when it comes to trading.
Care of feeding of high-yield funds
Of course, you don't get something for nothing in the investing world, and that applies in this situation. High-yield bond funds aren't going to give you that extra yield just because they like you. In return for that higher interest payment, you'll be asked to invest in less creditworthy companies. That means a greater risk of default. As a result, high-yield bond funds should serve a more complementary role in your portfolio, alongside other higher-quality bonds and bond funds.
If you choose to add a high-yield bond fund to your fund line-up, make sure you don't overdo it. Whereas folks with several decades left until retirement can probably stand to have half or more of their total bond allocation in junk bonds, retirees should probably limit their exposure to no more than 10%-15% of their total bond allocation. High-yield bonds can be an important add-on to your bond portfolio, but you need to be aware of their risks and use them cautiously.