Is Your Fund Courting Junk-Bond Risk?

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,

Meanwhile,

More-conservative high-yield funds like

Although they take on less credit risk than high-yield bond funds, multisector bond portfolios are also typically big investors in junk bonds.

Junk-bond exposure in intermediate-term bond portfolios is much more muted.