NEW YORK ( TheStreet) -- Since the financial crisis, high-yield bonds have soared. During the past three years, high-yield mutual funds returned 16.3% annually, according to Morningstar. Can the rally continue? Probably. High-yield bonds yield 7%. That is a tempting payout at a time when 10-year Treasuries yield 1.73%.
But high-yield bonds -- which are rated below-investment grade -- can drop sharply when investors sour on the outlook for the economy. To limit risk, consider strategic income funds. Besides high-yield bonds, the funds hold a mix of high quality and international issues. Portfolio managers change allocations as market conditions vary.
Top fund managers have proven deft at shifting holdings, emphasizing high-quality bonds in difficult times and increasing high-yield holdings to take advantage of rallies. During the turmoil of 2008, many of the strategic income funds managed to limit losses by emphasizing high-quality bonds, which stayed in the black. The best managers have surpassed both the average high-yield fund and the Barclays Capital Aggregate bond index. Strong performers include Federated Strategic Income (STIAX), Franklin Strategic Income (FRSTX), and John Hancock Strategic Income (JHFIX).9 Stocks That Prove Dividends Make All the Difference >> During the past 10 years, the Federated fund returned 8.2% annually, outdoing the average high-yield fund by 1 percentage point and topping the Barclays Capital Aggregate bond index by 2 percentage points. While many strategic income funds keep about one third of their assets in high yield, Federated takes a more aggressive stance. When the portfolio managers have a neutral outlook on the markets, they hold 40% of assets in high yield. The approach has enabled the fund to excel in rallies. Federated currently has 44% of assets in high-yield bonds. Portfolio manager Joe Balestrino says that the outlook for high-yield issues remains solid. The annual default rate is less than 2%, well below the historical averages. Defaults should remain under control since the economy is growing and balance sheets remain strong. "The economy is out of the woods," Balestrino says. In their neutral position, the Federated managers keep 25% of assets in emerging markets bonds. The fund currently has 31% of assets in the sector. Balestrino says that BBB-rated emerging market bonds yield about 5.5%, compared to a yield of only 3.8% for similar bonds in the U.S.