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Fund Spy

Is Your Fund Courting Junk-Bond Risk?

It's a good time to take stock of the credit risk in your portfolio.

After a rough stretch that lasted from mid-2014 through early 2016, junk bonds have been on a tear. The median fund in the high-yield bond Morningstar Category gained more than 20% from March 2016 through August 2017.

That’s left the spreads on junk bonds near their postcrisis lows. Spreads represent the additional yield offered by junk bonds over comparable U.S. Treasuries for the risk that the borrowers won’t repay their debt, so tighter spreads mean less compensation for lending to the market’s highly leveraged companies.

Funds that have invested in junk bonds have benefited from this strong rebound. But with valuations tight, they’re also vulnerable to losses should high-yield credit suffer from a slowing economy or in a flight to quality. Many bond managers are relatively sanguine about corporate fundamentals, although the U.S. economy is more than eight years into an expansion and there are some signs of risk on the horizon.

Toys 'R' Us is only the latest in a long list of bankruptcy filings that have hit the retail sector, for example, while managers note that loosening of bond protections could hurt recoveries in the next default cycle. Investors with junk-bond fund exposure should be comfortable with these risks and willing to ride through a credit market sell-off.

Within the high-yield bond category, funds with relatively large allocations to the lowest tiers of the junk-bond market--those rated B or below--are most at risk. So, for example,  Ivy High Income (IVHIX) stands out for its relatively large allocation to lower-rated junk bonds, with close to 30% of the portfolio in bonds rated below B as of August 2017.

Meanwhile,  BlackRock High Yield Bond (BHYAX) had a somewhat more moderate 19% allocation to bonds rated below B as of August 2017; that represented a slight overweighting relative to its Bloomberg Barclays US Corporate High Yield 2% Issuer Capped Index. That said, manager Jimmy Keenan notes that it has more-modest allocations to the highest-yielding--and thus riskier--names in this credit-quality tier.

More-conservative high-yield funds like  Vanguard High-Yield Corporate (VWEHX) and  PIMCO High Yield (PHYDX) that tread more lightly in the market’s riskiest names are also vulnerable to losses, albeit more modest.

Although they take on less credit risk than high-yield bond funds, multisector bond portfolios are also typically big investors in junk bonds.  Fidelity Strategic Income  (FSICX), for example, held a roughly 37% allocation to junk bonds and bank loans as of July 2017, while  Loomis Sayles Bond (LSBRX) dedicated roughly 22% of the portfolio to high yield as of August. That number has been higher in the past; manager Dan Fuss and his team at Loomis Sayles have trimmed the fund’s high-yield stake noticeably since early 2016, citing relatively tight valuations and the potential for geopolitical risk to spill over into the credit markets. That portfolio also had relatively modest exposure to the riskiest, below B rated debt.

Junk-bond exposure in intermediate-term bond portfolios is much more muted.  Fidelity Total Bond (FTBFX), for example, can hold a maximum of 20% of its portfolio in junk-rated corporates (including bank loans), and lead manager Ford O’Neil held only 12% in this sector as of July 2017, down from 15% in the first quarter of 2016.  Loomis Sayles Investment Grade Bond (LSIIX) is one of the category’s most aggressive funds, with large stakes in corporates, the occasional common stock, and non-U.S.-dollar currency. But it held roughly only a 11% stake in high-yield bonds as of August 2017, in line with its historic norms. Those stakes stand out relative to investment-grade-only options like  Vanguard Total Bond Market Index (VBMFX) but are small enough that they’re less likely to lead to big losses in a junk-bond sell-off.

Sarah Bush has a position in the following securities mentioned above: LSBRX. Find out about Morningstar’s editorial policies.