How to Boost Your Portfolio's Yield

"Is there anything out there yielding more than 5%?"

I get this question all the time from fund investors struggling to get a decent yield in this low-interest-rate environment. To be sure, there are funds with yields above 5%, but you have to be sure that they are right for you. The higher the yield, the greater the risk.

If you’re looking to boost your portfolio’s yield, the first thing to do is look for a fund with a lower expense ratio than the fund you own now. Finding lower expenses can boost your yield because expenses are subtracted from fund dividends. Thus, if you move from an intermediate-term bond fund that charges 1.00% to one that charges 0.30%, you’ve boosted your yield by 0.70% without increasing risk. Some of the lowest-cost bond funds can be found at Fidelity, Harbor, TIAA-CREF, and Vanguard.

If you try to get more yield by investing in a riskier fund, you could wind up losing income in the long run if those risks blow up on you. This is because you will have shrunk your principal, thereby cutting your future income streams. So, before taking on more risk, be sure you can hold the fund for a reasonably long time. This ensures that you won't have to redeem at a time when your principal is reduced. In addition, you should make sure the bond part of your portfolio isn’t out of whack. Unless you're deliberately taking on more risk, most of the portfolio should be in high-quality short and intermediate funds.

Exactly how much risk are you taking on for each additional percentage point in yield? Let’s take a look at the levels of yield offered by different types of bond funds--and how much risk is involved with owning them. I’ll use Vanguard funds as a benchmark because they’re usually the cheapest for retail investors. Any fund with a significantly higher yield than its Vanguard counterpart is going to be taking on more credit or interest-rate risk.

1%: Ultrashort Bond
You can’t earn even 1% a year in a money market fund these days, so we'll start with the ultrashort category. Vanguard doesn’t have an ultrashort fund, but  Fidelity Ultra-Short Bond  yields about 1.3% and charges 0.70%. You give up a little stability when you move from a money market to an ultrashort fund because the latter doesn’t maintain a stable $1 NAV the way that a money market fund does. Ultrashort funds have a little more interest-rate risk and credit risk than money markets, so you shouldn’t buy them unless you plan on holding them for at least six months. Since its 1994 inception,  Turner Ultra Short Fixed Income’s (TSDOX) worst six-month return was a loss of 0.12%.

2%-3%: Short-Term Bond
Moving from ultrashort to short means taking on a little more interest-rate risk. We put funds with durations (a measure of interest-rate sensitivity) that average between 1.0 and 3.5 years in this category. Those at the most conservative end are yielding just over 2%, while some of the bolder funds have yields north of 3%.  Vanguard Short-Term Federal (VSGBX) has very little credit risk and yields 2.11%.  Vanguard Short-Term Bond Index (VBISX) includes corporate debt in the mix and yields 2.42%. If you move up to funds that are all corporate, you can nudge into 3% territory. You should be prepared to hold a short-term fund for at least one year. Since its 1994 inception, Vanguard Short-Term Bond Index’s worst six-month return was a gain of 0.01% and its worst 12-month return was 1.50%.

4%: Intermediate-Term Bond
This is a big step. To get 4%, you’ve got to take on significantly more interest-rate risk. Many funds in this category have more credit risk, too, though they stay in investment-grade debt. Funds in this category generally have a duration of 3.5 to 6.0 years. Intermediate-term government funds (a separate Morningstar category) yield around 3%, so you have to go into a mix of corporates and government debt to get to 4%.  Vanguard Total Bond Market Index (VBMFX) yields 4.33%. To invest in an intermediate-bond fund, you should be prepared to hold on for three years or more. Vanguard Total Bond’s worst six-month return was a loss of 5.25%. That’s quite a difference from the short-term funds. Its worst 12-month return was a 3.73% loss and its worst three-year return was an annualized 4.43% gain.

The big gap between risks in moving from 3% to 4% shows why investors get into trouble when they reach for yield. It seems like it should require only a small increase in risk, but each move up in yield is a bigger gamble. Investors accustomed to better yields too often make the mistake of moving up to maintain yield without grasping what they’ve done.

5%: Long-Term Bond
Now we’re in nosebleed territory. To take the next yield steps, you have to bet the ranch that interest rates won’t go up, or you can buy a junk-bond fund and bet the ranch that shaky creditors will stay solvent and make their debt payments. If you go the route of interest-rate risk, there’s  Vanguard Long-Term Bond Index , which yields 5.44%. But it's such a big gamble. Interest rates may well have higher to go, and you won’t like it if they keep going up. For a sense of the downside you face with a fund like this, I’ll use one of the category’s older funds, Smith Barney Investment Grade Bond (SIGAX). The fund’s worst six-month loss was 10%, its worst 12-month loss was 12.81% and its worst three-year performance was an annualized gain of 2.07%. Basically, you’re almost to equity-level risk here. Even if you can hold for the long term, it doesn’t make sense to invest a sizable part of your portfolio in a long-term bond fund.

6%: High-Yield Bond
Remember a couple years ago when all those telecommunications companies started gagging on their debt? You do if you owned a high-yield fund like  Invesco High-Yield , which lost 16% in one 12-month span.  Vanguard High-Yield Corporate (VWEHX) is yielding 6.69%. With junk-bond funds, interest-rate risk is muted but credit risk is magnified. As with long-term bond funds, you shouldn’t put more than a small portion of your bond portfolio here.

Tax Distribution Estimates Available
Many of the largest fund companies have estimates of the capital gains distributions they will make this year. Most funds are either making no distribution or a very small one. T. Rowe Price, Fidelity, American, and Vanguard all have estimates out now.