Because high-yield, or junk, bonds are issued by firms with below-average credit ratings, they carry above-average risk. But junk bonds can be particularly lucrative in an expanding economy (which is currently the case).
Junk bonds now yield 5.9%, on average, compared with 2.6% for investment-grade debt. Despite some defaults and ratings downgrades in the energy and mining industries, default rates for junk bonds remain low overall, and they shouldn't increase substantially without a recession, says Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors. With the economy expanding at a 2% annual pace, he adds, investors can "reasonably expect" a return of at least 5% in the coming year from junk bonds.
Another good option these days is a close cousin of junk bonds: floating-rate bank loans. Companies with low credit ratings take out these loans to finance a merger or fund their business operations. The loans don't yield much at face value. But their coupons adjust with short-term market rates, making them a good bet to pay out more if rates keep rising.
Risks to your money
A downturn in the economy would push up default rates, which would ripple through the junk-bond market, pressuring prices. Another potential drawback is that junk bonds tend to trade infrequently; if investors rush for the exits, the market could freeze up, forcing fund managers to sell at fire-sale prices.
How to invest
VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) holds IOUs originally issued with investment-grade ratings but subsequently downgraded to junk status. If issuers of these "fallen angels" can recoup their investment-grade status, which happens on occasion, the bonds should rally, supplementing the fund's interest income.
Another ETF we like is SPDR Bloomberg Barclays Short Term High Yield Bond (SJNK). The fund homes in on junk bonds maturing within two to three years, off-loading most interest-rate risk. With a yield above 5%, the fund possesses a decent cushion against falling bond prices.
Kip 25 member Vanguard High-Yield Corporate (VWEHX) focuses on relatively high-quality junk. The quality tilt may hold back returns when the junk market soars, as it did in 2009 and 2010. But the strategy helps the fund stay ahead of the pack when the junk-bond market gets rocky. Annual expenses are just 0.23%.
Among bank-loan funds, Fidelity Floating Rate High Income (FFRHX) emphasizes firms with relatively strong underlying businesses. The fund doesn't yield as much as many of its rivals, but it also takes on less risk. For a higher yield, consider Loomis Sayles Senior Floating Rate and Fixed Income A (LSFAX), which delves into riskier loans.