Digging for Higher Yields in the Junkyard

With interest rates near rock bottom, investors need to take on a bit more risk if they want higher yields. In this environment, "junk" bond funds may help individual investors gain more income without the risk of owning individual bonds in danger of default.

If you’re a borrower, the current interest rate climate looks pretty good. Rates on mortgages and other loans are at historic lows and banks are beginning to loosen up some cash for qualified loan applicants. But if you’re a saver, things look pretty ugly. Rock-bottom yields on fixed-income securities like Treasuries, certificates of deposit, and money market funds are pinching budgets -- especially for those who rely on that income to pay for day-to-day expenses.

As fear of a double-dip recession or another market freefall has grown, investors have flocked to so-called safe-haven investments, such as Treasuries, pushing prices up and yields, which move in the opposite direction, down. Currently, if you’re willing to let Uncle Sam have your cash for the next 30 years, he’ll pay you about 3.8 percent interest. A 10-year Treasury note will get you about 2.7 percent. The shorter the term, the lower the interest rate, with the payoff on a two-year note hovering around 0.5 percent. Money-market funds are even worse, with yields close to zero.

In this kind of environment, investors willing to take on more risk are turning to high-yield, or “junk,” bonds, where yields can be double or even triple that of Treasuries. The risk, according to market experts, is that companies with less-than-stellar credit ratings will default on the bonds, leaving investors holding an empty bag. Junk bond yields are also at the mercy of economic conditions, much like stocks, and they often move in the same direction. For that reason, individual junk bonds aren’t a suitable place for the average investor to park cash. To lower the risk, most investors get into junk bonds through diversified high-yield bond funds.

Junk bond funds have a good track record during previous recessions. In the early 1990s, average junk bond fund performance was in the double digits. When choosing a high-yield fund, bond analysts advise looking for one that has a low expense ratio and enough cash to spread among several junk bond issues. A few long-term, top performers in the category are the Vanguard High-Yield Corporate Fund (VWEHX), the Fidelity Capital & Income Fund (FAGIX), and the T.Rowe Price High-Yield Fund (PRHYX)

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