What Place Do High-Yield Bonds Have in Retiree Portfolios?

And, what's the downside risk on a top-performing junk fund?
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Do high-yield bond funds have a place in the portfolio of a retiree? I recognize that the net asset value can fluctuate, but is a 20% drop a possibility when dealing with quality funds such as (VWEHX) - Get Report Vanguard High Yield Corporate, (SPHIX) - Get Report Fidelity High Income or (NTHEX) - Get Report Northeast Investors Trust? When looking at 5% from a money-market fund vs. 8% or more from a high-yield fund, the risk seems tolerable, unless an absolute meltdown occurs. Or am I missing something? -- Bruce Rosenbauer

Bruce,

The role of high-yield bond funds' role in a retirees' portfolio depends entirely on the retiree. If you can't stand much fluctuation in the value of your principal, then steer clear.

Having said that, high-yield bonds and funds are very well suited to retirees who

can

cope with fluctuation in the value of their principal, say experts in the asset class.

The basic principle is this: In exchange for taking the risk that their net asset value will drop sharply in an economic downturn (and that some principal might in fact be lost forever if a particular issuer defaults and goes out of business), high-yield funds pay investors fatter dividends than investment-grade bond funds do, corresponding to the bigger coupons attached to the high-yield bonds themselves.

The investment implication: You don't want to keep every last cent in a high-yield bond fund; you should keep some cash in a safe place. But if you can't get enough income from investment-grade bonds or funds that won't put your principal at so much risk, high-yield may be your ticket.

"I would say that generally, a retiree is a good candidate for a high-yielding fund because they're generally at a stage in life where they've accumulated the assets they're going to accumulate and are looking for income to supplement whatever retirement income they have," says Martin Fridson, chief high-yield strategist at

Merrill Lynch

.

"It's not a place to put assets you need for liquidity," Fridson says. "But presumably if you've been accumulating savings conscientiously, and at retirement you have your liquidity needs taken care of with savings accounts or money-market funds, high-yield is a pretty good asset for your other funds."

Marilyn Cohen, president of

Envision Capital Management

in Los Angeles, advocates a bit more conservatism if possible. It's prudent, she says, to cap one's high-yield allocation at 25%. The trouble is that "a lot of retirees cannot live on a Treasury yield or an investment-grade yield," Cohen says. "When a customer says 'I need 8% or 9% to live on; I can't live on less,' what are you going to do?"

As for whether "quality" funds can experience share-price drops of 20% or more, obviously, anything can happen. It's true that the funds you named are all solid long-term performers that held up better than average in last fall's junk-bond rout. (All also have significantly lower-than-average expense ratios, which means they can take less risk than their more expensive counterparts and produce the same results.) Over the three months ended Oct. 31, 1998, the worst-performing high-yield fund,

(DHIYX)

Dreyfus High Yield, experienced a 26.9% drop in share price. Over the same period, Vanguard's share price dropped 5.9%, Fidelity's fell 12.7% and Northeast's lost 13.2%.

But in the three months ended Oct. 31, 1990, Vanguard fell 15.5% and Northeast toppled 19.7%. (Fidelity's fund was started in August 1990.) Granted, what happened to the high-yield bond market in 1990 had more to do with structural problems in that market than with the economy's slowdown. It was, Fridson says, "a unique period in which the normal benefits of industry diversification got steamrolled by other types of risk that cut across the whole spectrum."

That doesn't seem likely to happen again. "In terms of probable outcomes, a 20% drop looks pretty rare," Fridson says. "If you think that Y2K is going to create such havoc that the whole world economy is going to go into a tailspin, then you should probably buy T-bills or gold. But short of that, I don't think anyone's put forth a plausible scenario that leads to a downturn comparable to what we saw in '89-'90."

That's not a guarantee, mind you.

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TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.