How to Pick a Good High-Yield Bond Fund

Christine Benz: Hi, I'm Christine Benz for Morningstar. What role do high-yield bonds play in a portfolio, and how can you pick a good one? Joining me to discuss that topic is Russ Kinnel. He's Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's talk about high-yield as a category. Its performance has been relatively decent over the past decade. How should investors decide how much, if anything, to allocate to this category at large?

Kinnel: Well, it's an interesting place where you get some really good returns but with some significant risks as well. So, it's higher return, higher risk. It can be a nice diversifier for a bond portfolio and an equity portfolio. But it's worth understanding that, because these are largely corporate bonds, and overall economically sensitive because they're lower quality, you have a higher correlation with the equity market in general. So, when you're factoring that into your plan, you should think about that--that core high-quality bond fund is going to be less like a high – like an equity fund, and less correlated and a little more of a ballast. This is kind of in between. So, it can be a good role player in that portfolio--just helpful to understand that--and to understand that every once in a while high-yield funds really take it on the chin. So, for instance, in 2008, they really got smacked. And since then, we've had a couple of events like the energy meltdown in 2014. But by and large, if you look at a fund's 10-year record, you might not even notice there's any risk at all.

Benz: It's been pretty smooth sailing recently. So, we're going to talk about some of your favorite high-yield funds, and you've organized them by the most aggressive to the least aggressive. So, let's start with the very aggressive one that you like--where maybe you even want to think of it as like a low-risk equity substitute rather than certainly part of your core bond portfolio. This is Fidelity Capital & Income. It's one we've liked for long time here at Morningstar, but let's talk about why you like it and why investors should be mindful of its risks.

Kinnel: That's right. Mark Notkin has done a really good job. He's a seasoned manager, but he's aggressive both in terms of sometimes owning equity, sometimes owning lower credit quality. You can see back in '08 the fund lost a fair amount, but we like that it really plays on Fidelity's core strengths, which is security selection. Fidelity has got a strong high-yield team, and they've done a very good job over time. But as you say, it does contain some risk and you certainly need to factor that in, especially that it's been so long since high-yield has really had a tough go of it.

Benz: Right. Another fund that you like, and the team has long liked is T. Rowe Price High Yield. That one is undergoing a manager change in early 2020. But let's talk about why it still is hanging in there with a high Analyst Rating. It's a Silver-rated fund still.

Kinnel: Actually, it's a Bronze-rated fund. We took it – it had been rated Gold under Vaselkiv. Rodney Rayburn is going to take the reins on Jan. 1, 2020. And that led us to lower it to a Bronze. As you say, it's still a relatively aggressive fund, but we think T. Rowe historically has done a very good job of being smart, aggressive, so not huge bets but taking on some credit risk at the right times. Rayburn doesn't have as long a track record as Vaselkiv and has run a smaller fund and not a pure high-yield fund. So, all of that led us to Bronze. But we still think he seems like a good manager, but also, there's good analyst support there at T. Rowe. So, that's why it's still a Medalist-rated fund.

Benz: Let's discuss PIMCO High Yield. This is another fund on your list. Also, let's discuss how investors who are do-it-themselves investors who don't want to pay sales charges, how they might access the fund.

Kinnel: Yeah. So, PIMCO is a firm that's very much focused on institutional investors. But their funds are accessible to retail investors. The A shares are ones you can buy without paying a load through No Transaction Fee supermarkets. The fees aren't great. They're OK.

Benz: On the A shares?

Kinnel: On the A shares. The institutional have a better price, reflecting that focus on the institutional market. But you can access them. And even though PIMCO, we often think of as aggressive--in this case, Andrew Jessop has kind of been tilting towards the more conservative side, concerned about various aspects of the high-yield market and done a very good job. So, again, if you factor in the fact that the market has done pretty well of late, and this fund might hold up a little better in a down market, they've done a very good job. So, we still like this fund a lot.

Benz: Toward the conservative end, a fund that you like is Vanguard High Yield Corporate. That does tend to be one of the mildest high-yield funds. Let's talk about it and its low fees, because I think that's a key attraction and goes hand in hand with the strategy.

Kinnel: That's right. Vanguard built the strategy around the fact that it's got very low fees. And the idea is, if you have really low fees, you don't have to have that much credit risk to have a high yield. So, they have a competitive yield, good returns, but it takes on significantly less credit risk than most of its peers. So, it does feel a little more defensive in nature than most of the funds. And that's not a bad thing, given as we've explained that it's been a long time since the market sold off. This is run by Michael Hong of Wellington. So, they have deep team at Wellington supporting this fund, and of course, super-low cost. So, Silver-rated fund. There's a lot to like here.

Benz: And people know Vanguard for its index funds. This is, as you say, an actively managed fund. And high-yield as a group is a category where we do tend to prefer active management versus some of the index products, correct?

Kinnel: That's right. There are ETFs that do high-yield, but then you've got some liquidity problems with high-yield. So, we're not a big fan of the high-yield ETFs.

Benz: Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.