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Getting Fat Bond Yields -- While Limiting Risk

NEW YORK ( TheStreet) -- Since the financial crisis, high-yield bonds have soared. During the past five years, high-yield funds returned 17.1% annually, compared to 7.2% for intermediate-term bond funds, according to Morningstar. The high-yield funds invest in bonds that are rated below-investment grade. After being clobbered in 2008, the low-quality bonds rallied sharply as investors regained confidence.

During the rally, funds that took on the most risk tended to do best. The aggressive portfolios focus on bonds that are rated B and CCC, the two lowest categories in the high-yield universe. Investors flocked to the low-quality issues that provide the most yield. Cautious funds did less well because they emphasized bonds rated BB -- the highest rating in the below-investment grade market.

Now that prices have climbed, this could be a time to consider the more cautious high-yield funds. Funds that hold big stakes of BB issues still pay rich yields, and they could prove relatively resilient if bond prices sink. Solid choices include Aquila Three Peaks High Income (ATPAX), Fidelity Focused High Income (FHIFX), RidgeWorth Seix High Yield (HYPSX).

BB-rated bonds currently yield 4.7%, compared to 5.4% for B and 7.6% for CCC. The extra yields of the lowest-quality issues come with substantially more risk, according to a study by Moody's. During a five-year period, 7.9% of BB bonds defaulted, while the rate was 20.7% for B bonds, and 39.3% for CCC bonds. Bond defaults can sharply erode fund returns.

At the moment, high-yield bonds are defaulting at an annual rate of around 2%. That is well below the long-term average of about 4%. Defaults are likely to remain low in coming months as the Federal Reserve continues to hold down rates. With rates at rock-bottom levels, high-yield companies can easily refinance their debt. But when rates rise, refinancing could become more expensive and default rates will climb. When that happens, high-yield funds that emphasize steadier bonds should shine.

A relatively solid fund is Fidelity Focused High Income. The fund has 70% of its assets in bonds that are rated BB or higher, compared to 35% for the average high-yield fund. The higher-quality bonds enabled the Fidelity fund to outdo 83% of its peers during the turmoil of 2008. During the past five years, Fidelity returned 14.4% annually.
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