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Fixed-Income Diversification: Adding High-Yield Funds by Paul A. Merriman Publisher and Editor Most investors understand the benefits of diversification in equity funds. Stick with only one fund and one style of investing long enough, and you’re almost sure to regret it. Diversify properly, and your returns will be better and your risk lower. A lot of investors don’t realize it, but the same holds true for investing in bond funds.
High-yield bond funds are shunned by many investors as too risky. These funds buy bonds issued by companies with lower credit ratings, companies that for one reason or another could have trouble meeting their obligations. Most of these bonds never go into default, and in the meantime investors willing to take the added risk can pick up higher yields.
High-yield funds that diversify in hundreds of such bonds keep their risks very manageable while they pay higher dividends, too.
High-yield bond funds may be too risky by themselves for many investors, just as emerging markets funds are uncomfortable for some stock investors. But in each case, if you hold a specialized fund inside a diversified portfolio, you can get the added benefits without taking undue risks.
Let’s see how this can work with high-yield bond funds.
We have often recommended that income investors divide their money three ways in Vanguard Short-Term Corporate (VFSTX), Vanguard GNMA (VFIIX) and Vanguard Long-Term Corporate (VWESX) funds.
Over the past 18 years, this combination has produced an annualized return of 9.2 percent for buy-and-hold investors.
In the table below, you will see the results from the same 18 years of combining these three funds plus Vanguard High-Yield Corporate (VWEHX) in equal amounts for a four-way diversified bond portfolio.
As the lines at the bottom of the table show, the four-fund combo produced a 9.2 percent annualized return with a worst-12-months loss of only 2.6 percent. You might expect a high-yield fund to bring higher returns, but in this period it underperformed two of the other three bond funds. And it did not add to the long-term return of the three-fund combination.
However, adding the high-yield fund made a dramatic difference in the area of risk reduction. The combination’s worst one-month and worst three-months losses were well below those of three of the four funds. And the worst-12-months loss for the combination was far below that of either the long-term or the high-yield funds.
This didn’t happen because the high-yield fund had less risk. As you can see in the table, the high-yield fund had the highest losses of the four funds. But the high-yield fund is a diversifier; its returns are non-correlated. In other words, the gains and losses of the high-yield fund occurred at different times than those of the other three funds. That smoothes out the overall returns of the portfolio, adding stability. And that stability is just what bond investors usually want.
In the two most recent calendar years, the high-yield fund lagged far behind that of the other three funds, illustrating that high-yield bonds don’t always produce high returns. But I believe that tide is likely to turn in the next year or so when interest rates start rising.
Higher interest rates probably will accompany better economic times. A stronger economy will make life easier for many issuers of high-yield bonds, improving the outlook for those bonds. And that should make the bonds more valuable.
In any case, a high-yield bond fund can add meaningful diversification to a fixed-income portfolio. That reduces risk. And that, in turn, makes it easier for long-term investors to stick with a plan and reap its rewards.
Source: http://www.fundadvice.com
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