Fat yields on corporate bonds: what to make of them, where to get them.
Twenty-year Treasury bonds yield 1.2%. Yields four times that high beckon from the bonds of lesser corporate borrowers. Worth the risk? Yes, if you know what you’re getting into.
This survey highlights 20 cost-efficient funds that own high-risk corporate bonds, a.k.a. junk bonds. It concludes with a deconstruction of those alluring yields. To give away the ending: You can get a decent return from these bonds, but it will be considerably short of the coupon yield you see.
Only one open-end, or mutual, fund makes the list of low-cost products: Vanguard High-Yield Corporate. Its Admiral share class (ticker: VWEAX; minimum investment: $50,000) has an expense ratio of 0.13%, or $13 a year per $10,000 invested. The fund has $27.2 billion in assets, a 3.5-year duration that indicates a fairly low interest rate risk, and a payout that annualizes to 5.1%. Credit quality of the portfolio: at the upper end of single-B.
There’s a richer collection of high-yield funds of the exchange-traded variety. The Best Buys include 14 ETFs that hold domestic junk bonds and 5 that hold either emerging-market bonds or a global mix.
Sources: Morningstar, YCharts
The tables are sortable by yield, expense ratio and so on. Tickers will take you to useful pages on the Morningstar website.
To get on this buy list a fund must run up expenses no higher than 0.35% annually and have assets of at least $10 million. If it’s exchange-traded, it must see at least $100,000 a day in average trading. One of the funds, ticker PFFD, owns preferred stock rather than junk bonds; the risks and yields of preferreds are similar to those of junk bonds.
Those 5% payout yields are intriguing. They need to be taken down a peg in your mental arithmetic of expected returns. There are three reasons.
First: Many bonds trade these days at a premium to par value, a premium that is destined to evaporate. If a bond with a 6% coupon is trading at 104 cents on the dollar, but will be redeemed at 100 in two years, then your principal is being erased at a rate of 2% and your true yield to maturity is more like 4%. But if the fund bought the bond way back when at par, it will be basing its distributions on the coupon and will show a yield from it close to 6%.
Next little problem is defaults. Some high-yield corporate borrowers go bust, with bondholders recovering maybe 50 cents on the dollar. Some governments, especially in Latin America, borrow money and then decide that they are not necessarily obliged to repay it.
The last pothole relates to call provisions. Corporate borrowers almost always reserve a right to call in a bond, which means redeeming it early. They’ll do that if circumstances permit them to borrow more cheaply by issuing new bonds at a lower rate. It’s like a homeowner refinancing a mortgage.
Companies that prosper refinance, snatching away the premium coupon you were banking on. Companies that get into financial trouble stick around in your portfolio. Heads you break even, tails you lose. It’s a lopsided bet.
The Securities & Exchange Commission makes an effort to help naive investors. It requires funds to disclose an “SEC yield” that takes into account the first of the three ways that returns fall short of fund payout rates. The other two problems are beyond the agency’s skill set.
The SEC yield not being especially enlightening, the tables above show payout rates (trailing 12-month income distributions divided by fund share price). Knock a percentage point or two or three off to arrive at a guess at what kind of total return to expect. There is no scientific method to calculate future results. The future depends on whether the Federal Reserve is successful at creating inflation (which would help weak borrowers) and preventing a long recession (which would have the same effect).
Here’s a reference point to guide you. That Vanguard open-end junk fund is one of the longest-running, at just shy of 42 years. It’s an excellent fund, averaging an 8% total return annually over its history. And yet its principal has been eroding at a rate of 1% a year. Coupon yields, that is, have been high enough to more than compensate for defaults. But the erosion is a hint that no amount of dexterity by a money manager can prevent principal losses in a junk portfolio.
My guess on the junk sector is for a total return (yields minus principal losses) in the neighborhood of 3%. That would make junk a reasonable diversification in a retirement portfolio, but no terrific bargain.
