This article was last updated on April 16, 2022
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High-yield bond funds are seeing record inflows, but experts warn the best times may have already passed.
Investors who had hid in safe havens are heading toward far riskier territory: junk bonds. But with yields on these bonds already starting to shrink, even the pros are asking: are they late to the party?
Investors have poured $8.8 billion into high-yield, or “junk,” mutual funds and exchange-traded funds since Sept. 1, according to fund researcher Lipper Inc. That’s a sharp reversal from August, when they yanked $6.7 billion from these funds. Over the past week alone, they’ve added a whopping $4.2 billion to junk bond funds, the highest amount since Lipper began tracking the funds in 1992.
What changed? Advisers say investors, comforted by recent economic reports that show the U.S. may avoid a double-dip recession, are more willing to embrace risky assets like high-yield bonds. The allure, of course, is their yields. Junk bonds are currently yielding about 8%, compared to 2% for 10-year Treasury bonds and 3% for high-quality corporate bonds. That has prompted several large financial firms — including J.P. Morgan, Barclays Capital and Northern Trust — to recommend junk bonds to their clients in recent weeks.
Not everyone is so smitten. In a September article, Fidelity pointed out that high-yield bonds can be more volatile than Treasurys or high quality corporate bonds. And in the company’s last quarterly outlook, Pacific Investment Management Co.’s senior portfolio manager Saumil Parikh said concerns about the global economy and the risk of a recession in Europe are pushing the firm to cut back on lower-rated bonds to focus on high-quality assets. Junk-bond issuers typically have less financial strength than companies with higher bond ratings, say investing pros, and are therefore more prone to economic downturns.
Indeed, other junk-bond bears point out that the high-yield bond market is notoriously moody, with investors often bailing out the investments at the first sign of economic trouble. For that reason, Wilmer Stith, manager of the $120 million MTD Intermediate Term Bond fund (ARIFX), recently cut back his exposure to high-yield bonds from 15% to 2%. “We prefer to have the political uncertainty behind us,” says Stith.
Even some fans of high-yield bonds note that their surge in popularity is already pushing yields down compared to Treasurys. Junk bonds are currently yielding about 7.5 percentage points over comparable Treasurys, down from 9 percentage points at the beginning of the month, according to the Merrill Lynch High Yield Master II Index. While that’s higher than the average 5-percentage-point spread seen for the first half of the year, advisers point out that investors are getting paid less for taking on the extra risk than they did just a few weeks ago.
Despite the drawbacks, many investing pros say junk bonds still have plenty going for them. The default rate on these bonds is currently just 2% and could fall further, says John Lonski, chief economist for Moody’s Analytics. On top of that, many of the neediest companies have strengthened their balance sheets and reduced their near-term debt, meaning they’ll be able to keep up with payments, says Frank Fantozzi, president of Planned Financial Services, a wealth management firm in Cleveland. “Companies are very stable right now,” says Fantozzi. “I just don’t see the level of risk.”
The inflows might continue in the short term, as investors are encouraged by higher than expected economic growth and the announcement of a debt deal in Europe, says Jeff Tjornehoj, senior analyst at Lipper. But they might just flee the bonds again before year end, he warns, if they’re disappointed by the way the European debt deal is implemented. And investors have moved in and out of the funds several times already this year: after pulling more than $7 billion from high-yield bond funds in June, investors put $3 billion into them in July and then pulled nearly $7 billion from them in August. “Lately they’ve been fickle,” says Tjornehoj.
For those looking to invest in a junk-bond fund, experts recommend seeking out offerings with an expense ratio that’s less than the 1.2% average, says Todd Rosenbluth, a mutual fund analyst for S&P Capital IQ. They should also look for funds with a long track record and be aware of the overall credit quality of the fund, he says.
Rosenbluth says some of the stronger funds in the high-yield category include the$4.2 billion Fidelity High Income fund (SPHIX), which has returned an average 20% annually over the past three years, compared to an average 18% return for other high-yield bond funds. The fund charges 0.75%, or $75 for every $10,000 invested. Investors seeking a fund that invests in higher quality bonds might consider the $13 billion Vanguard High-Yield Corporate fund (VWEHX), which has gained an average 19% a year for the past three years. The fund charges 0.25%, or $25 for every $10,000 invested.
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