High-yield bonds add tremendous value at times, so it makes sense to at least consider investing in them. They've had terrific returns in recent years. In 2016, they outpaced both stocks and higher quality bonds.
They can also be useful in a rising interest-rate environment, since their higher yields could help offset a decline in bond prices. In the second half of 2016, when the 10-year Treasury yield rose from 1.49% to 2.45%, higher quality bonds lost money while high yields gained over 6.5%.
What you should know about high-yield bonds
You need to use high-yield bonds carefully because these funds are risky. These are lower credit quality (“junk”) bonds, so they have a higher risk of default, and defaults tend to increase when interest rates rise.
High-yield bonds also can be quite volatile compared to other bonds. They are typically more correlated to stock markets, and that can make it hard for investors to hold these bonds long term. During the 2008 credit crisis, some high yield bonds lost 25-30%.
Ideally, you’d own high-yield bonds when they’re doing well and you’d avoid these bonds when they’re out of favor. This may seem unrealistic, and yet it’s what our fixed income approach is designed to do.
When to own (and when not to own) high-yield bonds
The FundX Flexible Income strategy has a proven track record of moving us into high yields when they have strong recent returns and steering clear of these bonds when they’ve lost momentum, as you can see in the chart below.
We didn’t have to predict how high yields were going perform in advance. Instead, we simply followed our strategy and bought into the funds that were excelling in the current market environment.
Tip for using high-yield bonds in your portfolio
Since high yields can be volatile, we suggest using them as part of a diversified bond portfolio. In the bond portfolios we manage, we also limit our exposure to these bonds.
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