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Do Big Yields Always Mean Big Risks?

Some funds strike a better balance than others.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Given the current low-interest-rate environment, many investors are scrambling for yield. But screening for funds based on yield alone can be risky. In the latest issue of Morningstar FundInvestor, editor Russ Kinnel takes a look at high-yielding, highly rated funds, and he's here today to share his findings with us.

Hi, Russ. Thank you for being here.

Russ Kinnel: Hey, good to be here.

Dziubinski: You specifically screened on the 10 highest-yielding funds in the Morningstar 500, and the Morningstar 500 is a list of some of the biggest and highest rated mutual funds that Morningstar tracks. What are some of the general findings from that exercise?

Kinnel: Well, I think, generally, it obviously takes you to funds that are taking on significant amount of risk to get a yield. And in today's environment, you have to take on a fair amount of risk to get a decent yield; even though we had an interest-rate spike early in the year, as the economy stabilized, interest rates became quite low. And so, you do have to take on a fair amount of risk, and you certainly want to appreciate that going in. If you want to return your portfolio to income levels of the past, recognize that doing that may well mean increasing risk. But I think if you're diversified and careful, you can do so without too much risk.

Dziubinski: There were a couple of different fund categories that came up more than once in this list, the first being high-yield corporate-bond funds. And the three funds that were on the list specifically were Hotchkis & Wiley High Yield, T. Rowe Price High Yield, and Fidelity High Income. Let's talk a little bit about some of the risks of high-yield bond investing in general, and then how these funds have managed it.

Kinnel: Sure. Well, you can start by just going back a year ago to the first quarter of 2020 and seeing in the COVID sell-off all three of these funds lost between 22% and 23% of their value. So, it's really clear that this is a group that's very economically sensitive. Of course, high yield means you've got companies with a lot of debt. And if you have a lot of debt and the economy goes south, all of a sudden, things look risky. So, that's what happened. But then the rest of the year, those funds all rallied to actually manage to get slightly in the black, and I think that illustrates the risks and the appeal there, that there is significant risk. These are well-run funds. All three of them are medalists, but you're still taking an amount of risk, and you have to appreciate that going in.

Dziubinski: Another category that came up more than once was emerging-markets bond funds. The three funds specifically were Pimco Emerging Markets Local Currency and Bond, T. Rowe Price Emerging Markets Bond, and Fidelity New Markets Income. So, again, let's walk through some of the risk/return payoff with those particular funds.

Kinnel: That's right. I think emerging-markets bond is even another level of risk beyond high yield. So, definitely, tread carefully here. Don't make it a big part of your portfolio. But what's interesting there is that we have three well-known shops, firms we really like that have a lot of good bond efforts, yet all three funds are Neutral-rated. And the reason is, it's hard for even those firms to find the right mix of strategy and people, and in all three cases, they're a little bit in flux because it really is a hard thing to do. Emerging markets have been a place that have regularly gotten smacked and so it's a pretty treacherous area. But at the same time, there are good yields. There's good diversification value there. So, I wouldn't ignore it.

Dziubinski: Lastly, Russ, a few equity funds made that top-10 list. What would you say to investors who are looking at higher-yielding equity funds? What should they be paying attention to when they're evaluating these funds for their portfolios?

Kinnel: I think it's really important to find a good manager and strategy when you're looking at equity-income because simply buying based on yield could lead you to some really high-risk strategies. So, you really want a fund that's well-run and not taking on too much risk, has a good diversified portfolio, isn't leaning too heavily on, say, energy or utilities. But if you do all that, you can find some really good funds. And because value has lagged, you can actually get a pretty decent yield, too.

Dziubinski: Well Russ, thank you so much for this very valuable perspective today on high-yield investing in this tough, low-yielding market. We appreciate your time.

Kinnel: You're welcome.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

Russel Kinnel has a position in the following securities mentioned above: PRHYX. Find out about Morningstar’s editorial policies.