Reaching for High Yields Can Be Dangerous

Buying junk bonds and long-term funds in today’s market could lead to big losses. Consider municipal bonds instead.

Income nowadays from bank accounts, certificates of deposit, money-market funds and just about every other short-term savings vehicle is pathetic. The temptation to reach for yield is enormous.

But if you own a fund with the words high yield or high income in it, your fund almost certainly invests largely in junk bonds -- issuers of which stand a high chance of defaulting on their debt. Similarly, if you own a fund with the word long in its name (as in long term), your fund will likely suffer serious damage when bond yields inevitably rise.

Junk-bond funds were hammered in 2008, plunging an average of 27%, Morningstar reports. At their nadir in November 2008, junk bonds yielded an average of 22%. Those wise enough to bet that the financial meltdown wouldn’t precipitate a second Great Depression made a boatload of money. In 2009, junk funds returned 46% on average, and they’ve tacked on another 4% so far this year through April 15.

The easy money has been made. Today, junk bonds yield about 8.1% on average. That’s 4.3 percentage points more than the yield on ten-year Treasury notes, which come with essentially no default risk.

Funds that own a lot of Treasuries were one of the few groups to thrive during the horrible market of 2008. The average long-term government-bond fund, which includes turbocharged zero-coupon Treasury funds, earned nearly 30% that year. The group surrendered nearly 17% last year and is up slightly so far in 2010. General long-term-bond funds, which invest mostly in corporate debt, held up reasonably well in ’08, losing just 2.6% on average. They gained nearly 15% last year and about 3% so far in 2010.

The salad days are over for both junk funds and high-quality long-term funds. Robert Auwaerter, head of fixed-income investing at Vanguard, recommends that you limit your holdings in junk-bond funds to 5% to 10% of your overall bond investments. He’s more leery of long-term-bond funds. “You’re not getting paid [enough] to own long-term bonds,” he says. “Interest rates have only one way to go.”

By that, he means rates have nowhere to go but up. If he’s right -- and I think he is -- that’s bad news for holders of long-term-bond funds because bond yields and prices move in opposite directions. In other words, if you own a long-term-bond fund, you stand a good chance of seeing its value decline over the coming year. Looking at the maturities of your bonds or bond funds can help you determine how much risk you face from rising rates. Duration is a more accurate risk measure. It tells you how much your bond or bond fund should fall in price if rates on similar bonds rise by one percentage point. For instance, the duration of Vanguard Long-Term Bond Index fund (symbol VBLTX), which invests in U.S.-government and high-grade-corporate bonds, is 12.1 years. If long-term-bond yields rise one percentage point, the fund’s price will likely plunge 12.1% (that decline would be offset to some degree by the fund’s current yield, now 5.2%).

Investors haven’t seen a sustained rise in bond yields -- and gut-wrenching losses in bond prices -- since the high-inflation 1970s and early ’80s, when bonds were dubbed “certificates of confiscation.” The worst year since then was 1994, when long-term-bond funds dropped more than 7% on average.

With the federal funds rate (a short-term interest rate set by the Federal Reserve) at zero to 0.25%, and Uncle Sam awash in debt, many bond gurus think the three-decade decline in bond yields that began in 1981 under Federal Reserve Chairman Paul Volcker is history. “It’s not worth taking a lot of risk now,” Auwaerter says. “There’s no sense locking in your money for a long period of time.”

Where to put your money now

What should you do with money that you can’t afford to risk in the stock market? Auwaerter advises short- and intermediate-term bond funds, particularly tax-free municipal bond funds.

Vanguard offers some of the highest-quality muni funds, and its funds usually boast the lowest expense ratios -- a crucial factor when investing in bonds. My favorite, Vanguard Intermediate-Term Tax-Exempt Bond (VWITX), yields 2.9%. No, 2.9% won’t make you rich, but this fund is unlikely to inflict serious losses. For someone in the 25% federal income-tax bracket, its yield is equivalent to 3.9% on a taxable bond. Should yields rise one percentage point, the fund’s price would be expected to fall about 5.5%. Annual expenses are just 0.20%.

Want to take even less risk? Vanguard Limited-Term Tax-Exempt (VMLTX) yields only 1.3%, but it will likely drop just 2.5% in price if yields rise by one percentage point.

Munis aren’t without credit risk. Many state and local governments face enormous fiscal challenges. That’s ample reason to stick with a high-quality, diversified fund rather than buy individual bonds.

I think short- and intermediate-term muni funds are the best of a bad lot for conservative income investors. Seniors who count on investment income to help pay the bills or to buy extras are being sold a bewildering array of other products that are overpriced and often dangerous, such as variable annuities. They’ll likely do much better investing 30% to 50% of their money in conservative stocks or stock funds, in my view.

Auwaerter sums up the yield dilemma. “There’s no magic answer. If there were, I’d give it to my parents, who are about 80. It’s just not worth taking a lot of risk now.”

Steve Goldberg (bio) is an investment adviser.

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