Finding High Yield With Less Risk

Inflows into bond funds continue to be brisk, and among the strongest categories is high-yield, or junk, bonds. This high-risk, high-reward sector was second only to intermediate-term bond funds for net inflows in January, with $6.1 billion added. During the past year, high-yield bond funds have added nearly $17 billion in assets, behind only the intermediate-term ($46.4 billion), world ($20.8 billion), and diversified emerging-markets ($18.9 billion) bond categories. (Click here for the latest Morningstar fund flows report.)

High-yield bond funds have returned 5.2% so far in 2012, coming off a gain of just 2.8% in 2011. The recent runup in high-yield bonds is indicative of optimism about the economy, as a better economy reduces the likelihood of defaults. Investors excited by the prospect of using high-yield bond funds to juice returns need to tread carefully, however. High-yield funds are high-yield for a reason, namely because they typically consist of issues with low credit quality and higher risk of default, making them among the most volatile of bond classes. Recall that in 2008, high-yield bond funds lost an average of 26.4% amid the collapse of global credit markets. Any downturn in the current economic recovery could have a similar negative effect on returns for high-yield bond funds. In addition, high-yield bonds tend to move in sync with stocks, so, in contrast with high-quality bonds and bond funds, they are not useful to counterbalance the equities in a portfolio.

That said, high-yield bond funds do offer the potential for higher returns than high-quality bonds and may be used to complement core bond funds with lower risk profiles. To search for funds that meet the criteria of potentially strong returns with reduced risk, we used Morningstar's  Premium Fund Screener to search for high-yield bond funds with below-average risk ratings that performed in the top quartile of the category in 2008 and have expense ratios of 1.0% or less. Premium users can click  here to view the screen themselves. Here are three funds that are part of this group.

 Vanguard High-Yield Corporate (VWEHX) (
)One of the largest high-yield bond funds, this offering from Vanguard tends to hover toward the higher-quality end of the junk-bond spectrum. About 57% of its holdings are rated BB or better (as of Dec. 31), compared with about 40% for the average high-yield bond fund. This conservative approach means the fund tends to lag its peers when funds tilted toward more speculative bonds do well, but it has also helped protect it from deeper losses in down markets. Its 21.3% decline in 2008 beat its peer group by more than five points. Keep in mind that, due to its higher-quality holdings, this fund also has greater interest-rate sensitivity than many of its peers. On the other hand, its rock-bottom 0.25% expense ratio means management doesn't have to take on extra risk to deliver a competitive return and yield.

 Janus High-Yield (JNHYX) (
)This fund doesn't do anything fancy, more or less staying in the vicinity of category averages for credit-quality allocation. But with this middle-of-the-road approach the fund has performed admirably over its lifetime. The fund's outperformance during the 2008 downturn was particularly impressive as it lost just 19.3%, or seven points less than its peer group. Its expense ratio of 0.76% is below-average for the category. The fund's D shares (featured in the screen) can be purchased via financial advisors or third parties, such as  Charles Schwab (SCHW) and  T. Rowe Price (TROW) .

 Metropolitan West High Yield Bond (MWHYX) (
)This fund's average duration (a measure of interest-rate sensitivity) of 2.3 years is on the short side, which should help it weather potential interest-rate increases better than its peers. The fund's managers favor floating-rate loans and securities as a further defense against rate sensitivity but aren't afraid to take risks that could cause this fund to lag its peers. Management takes a value-oriented approach, focusing on bonds that appear to be trading cheaply based on their asset values, cash flows, and seniority levels. The fund's whopping 54.7% return in 2009 beat its peer average by nearly eight points. This came one year after limiting losses to 21.6%, almost five points better than the category average. So far this year the fund has returned 4.0%, about a point below average for the group. Fees are a reasonable 0.8%. 

Performance data as of Feb. 27, 2012.