High-yield mutual funds offer an alternative to low-grade bonds for investors who can accept additional credit risk, and also help diversify a portfolio.
Even though HY MFs, in aggregate, have seen relatively stable returns, many funds have experienced outflows in certain months due to interest rate concerns; the chart below depicts this phenomenon.
Economic Conditions
During the COVID-19 crisis, many of the weakest corporate issuers in high-yield bond (HYB) and bank loan (BL) markets defaulted. This helped clean out their investment universe, leaving only stronger issuers with healthy financial habits and long-term growth potential standing. Now these survivors stand a much greater chance of upgrading as their creditworthiness improves due to better repayment records, better business performance, or stronger future prospects.
But exposure to these types of bonds can present certain risks for funds. Mainly when they invest in higher-risk issues that are more sensitive to interest rate movements and may exhibit greater volatility than other bond assets. Therefore, BL and HYB management teams must carefully balance risks versus potential rewards when choosing which investments to hold.
One way to mitigate risks associated with high-yield investments is selecting a manager with extensive knowledge in bottom-up credit research and an established track record in security selection. An experienced management team such as this can identify pricing inefficiencies in the market, such as mispricings of credit quality or default risk among individual high yield issuers, and take advantage of them by taking advantage of pricing inefficiencies in pricing mechanisms that may exist, taking advantage of mispricings would provide significant opportunities.
A quality high-yield mutual fund should provide investors with required yields without incurring too much volatility or risk. Numerous open and exchange-traded funds offer such returns, including Fidelity Advisor High Income Advantage Fund – Class M FAHYX, American Funds High-Income Trust A AHITX and Buffalo High Yield Fund BUFHX.
These top-rated funds have all earned a Zacks Mutual Fund Rank of 1 (Strong Buy), making them perfect choices to boost income from investment portfolios while diversifying them. Their lower exposure to more volatile, speculative junk bonds helps mitigate fluctuations in interest rate changes while they invest in bonds rated one level below investment grade for maximum yield potential. Finally, with reliable track records and low fees fees attached to them – perfect for investors seeking higher yields from investment-grade corporate bonds!
Credit Ratings
High-yield investments offer higher interest rates than investment-grade bonds but are usually considered speculative and carry greater risk. Their lower credit ratings could be caused by poor business performance, unfavorable economic conditions, or cash flow issues; their price movements also tend to be more volatile and they are more susceptible to defaults than investment-grade bonds.
Investors looking for high-yield bond portfolios with solid track records should prioritize funds with lower expense ratios and a diversified mix of debt.
Many investors use high-yield funds as diversifiers or replacements for lower-rated corporate bonds in their portfolios. Some funds specialize in one sector or issuer while others take a comprehensive view of the high yield market by investing across all industries and credit tiers.
Vanguard High-Yield Corporate Fund Investor Shares (VWEHX), for instance, received four stars from Morningstar and offers an attractive 1.3% SEC yield after expenses. Other comparable funds are the USAA High Income Fund (USHYX) and Janus Henderson High Yield Fund (JAHYX).
No matter their rating, high-yield bonds can gain from an improvement in an issuer’s creditworthiness. This may include better repayment performance, improved business operations, or favorable economic conditions – any of which could lead to their reclassification as investment-grade bonds, with their yields rising.
Even while investors should remain mindful of the risks involved with investing in high-yield bonds, they can find rewards with proper research and diversification. Furthermore, investors should take note of any tax advantages these funds may provide which might offset some of their higher risk profiles.
Higher-yield bonds tend to be issued by companies that are less financially secure, increasing the likelihood of default payments when economic conditions worsen, so investors should closely monitor creditworthiness of underlying businesses to minimize risk. But it is wise for any investor to consult a reputable advisor and thoroughly research potential investments before making their purchase decision.
Features of Bonds
Bonds are debt instruments that promise the return of principal and interest at an agreed-upon date in the future. Bonds offer investors a way to diversify their portfolio by adding steady sources of income and protecting against inflation. Individual investors may buy individual bonds; for higher yields, they could consider mutual funds or exchange-traded funds (ETFs), which offer economies of scale and professional management.
Investment-grade bonds tend to exhibit a low correlation with stocks and other asset classes, making them an attractive addition to a diversified portfolio. But investment-grade bonds may not suit everyone. High-yield bonds provide additional diversification through income generation as well as adding income. Unfortunately, however, they’re more volatile than investment-grade bonds and should only be added if appropriate for your portfolio.
High-yield bonds typically feature lower credit qualities than investment-grade bonds, classified as below BB (considered speculative for taxable bonds) or unrated. Furthermore, their shorter maturities make high-yield bonds more exposed to changes in both economic conditions and interest rates.
High-yield bonds offer financing opportunities to companies in financial distress that may also have higher risks of default than investment-grade companies, including former investment-grade firms and non-investment-grade firms alike. The high-yield bond market provides financing solutions to firms seeking working capital or acquisition funding.
Bonds’ most significant element is their face value, representing the company’s promise to return investors’ investments. Investors can review primary documents like prospectuses and bond terms to assess a company’s financial health and understand its creditworthiness.
Bond investing generally represents lower risks than equity investment because they provide a steady source of income. Before adding high-yield bond funds or exchange-traded funds to your portfolio, however, it’s essential to review your goals and risk tolerance beforehand. Consulting a financial advisor is best practice in helping evaluate all of the available options; information found here should not be used as tax, investment, or financial advice.
Taxes
Investors frequently turn to high-yield bond funds to increase the yield in their portfolio and diversify holdings or reduce credit risk. It is essential that they be aware that there can be tax implications attached to such investments.
High-yield junk bond mutual funds generate interest income that is subject to ordinary income tax rates, making these investments unsuitable for most taxable statements. It may be possible to hold junk bonds within such statements if their focus is municipal bonds issued by local governments to cover expenses or specific projects; such investments do not fall under federal or state or local taxation, respectively.
High-yield bond funds tend to experience greater volatility than other fixed income instruments due to their investments in riskier bonds, increasing both default and interest rate risks for investors. Professional management and diversification strategies may help limit these risks for their benefit.
Consideration should also be given to a fund’s turnover ratio and holdings when selecting one. A fund with a high turnover can trigger significant capital gains taxes when selling shares. In contrast, funds that own dividend-bearing stocks or bonds with coupon payments could incur additional taxes when selling these investments. To minimize potential tax issues, opt for investing in low-turnover funds with non-dividend-bearing stocks and zero-coupon bonds instead.
The information provided does not consider the individual investment objectives, risk tolerances, and financial circumstances of any particular investor and therefore may not be suitable for all. Performance data quoted represents past performance and does not guarantee future results; return and principal value fluctuations mean shares redeemed may be worth less than when originally invested. Performance data for periods other than one year are annualized.
