Race to Safety: Best High-Yielders

NEW YORK ( TheStreet) -- Struggling to obtain income, investors have raced to buy high-yield bonds. High-yield funds have returned 7.9% this year, compared to a gain of 3.7% for the Barclays Capital Aggregate bond index, according to Morningstar. Attracted by the strong returns, investors have poured $16 billion into high-yield funds this year, a big gain for a category with $227 billion in total assets.

Now some analysts worry that too much cash is rushing into high-yield bonds, which are rated below-investment grade. Fund companies apparently share the concern, and they have shut portfolios to new investors. Funds that closed recently include T. Rowe Price High-Yield ( PRHYX) and Vanguard High-Yield Corporate ( VWEHX).

Should you avoid high-yield bonds entirely? Not necessarily. Default rates are low, and the bonds pay competitive yields. But to limit risks, consider funds that hold short-term high-yield securities. Bonds with maturities of two or three years have tiny default rates, and they yield 3% to 5% -- a rich payout at a time when 3-year Treasuries yield 0.28%.

When interest rates rise, many bonds sink. But short-term securities often prove resilient. Funds that hold short-term high-yield bonds include Intrepid Income ( ICMYX), RiverPark Short-Term High Yield ( RPHYX) and Thornburg Strategic Income ( TSIAX).

Intrepid Income ranks as one of the most cautious funds in the high-yield category. Besides buying short-term securities, the portfolio managers avoid the shakiest issues in the high-yield universe. "We are trying to offer a higher-quality alternative that is somewhere between investment-grade funds and typical high-yield funds," says portfolio manager Ben Franklin.

When the Intrepid managers can't find bargains, they hold cash. In June 2008, the fund had 33% of assets in cash. That helped to limit losses when markets collapsed later in the year. But the high-quality securities lagged in 2009 when the market soared. The fund currently yields 4.4%, compared to a yield of 5.7% for the average high-yield fund.

Another stable choice is RiverPark Short-Term High Yield. The fund has an average maturity of five months, and most holdings recently had maturities of 60 days or less. RiverPark yields 3.7%. "We are trying to provide higher yields on cash for investors who have a time horizon of at least three or four months," says portfolio manager David Sherman.

Sherman hopes to deliver steady annual returns of 2.5% to 4.0%. In the past year, the fund returned 3.7%. RiverPark has proved resilient in downturns, suffering only minor losses during months when most competitors sank deeply into the red. When fears about the debt-ceiling standoff sank risky assets in the third-quarter of 2011, high-yield bonds lost 6.7%, and RiverPark lost 0.07%.

Sherman likes securities where the chances of default are extremely unlikely. Many of his favorite holdings are redeemed bonds. In a typical deal, a company calls its bonds, indicating that investors must turn in their securities and receive the principal back in a month. Sherman likes to own the securities during the last 30 days. To avoid trouble, he only participates in deals where companies have plenty of cash on hand to make payments.

Thornburg Strategic Income can range widely, buying bonds of different maturities. Recently portfolio manager Jason Brady has been emphasizing short-term high-yield bonds. Many of his holdings have maturities of three to five years and carry ratings of BB, one step below investment grade. The bonds yield around 5%.

While Brady can buy bonds from around the globe, he is particularly keen on small U.S. issuers that get most of their sales in North America. "These companies tend to be less directly affected by the mess in Europe," Brady says.

He figures that his short bonds will provide some protection against rising rates. If you buy an eight-year bond, you have to worry that rates will rise before the bond matures. That could push down the price.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.