High-yield bonds offer more income and the potential for greater capital appreciation relative to Treasury bonds. Investing in high-yield bonds through exchange-traded funds (ETFs) or mutual funds can help diversify the risks of investing in a single issuer.

High-Yield Bond Characteristics

High-yield corporate bonds are issued by companies that carry a credit rating of Ba/BB or below. Such credit ratings are assigned to bonds with higher default risk. Investors are compensated for this added risk with coupons (interest payments) that are higher than those paid by investment-grade issuers, sometimes significantly higher.

During times of rising rates, financing and borrowing becomes more expensive, and high-yield issuers could struggle to make interest payments and return the principal. Call provisions are also common and allow the issuer to buy the bond back if it is beneficial to issue new debt at a lower rate.

For these reasons, high-yield bonds can be volatile, and in a slowing economy they may underperform as profits decline. High-yield bonds are also referred to as junk bonds because of their greater risks.

Duration and credit quality are benchmarks investors should be cognizant of when thinking about fixed-income securities. A mathematical measure, duration is the average time it takes to receive all the cash flows. Bonds with higher durations typically have higher maturities and lower coupons and are more sensitive to value changes due to interest rate fluctuations. The “back of the napkin” calculation to an approximate expected change in a bond’s value is multiplying the interest rate change by the bond’s duration. Bond prices move inversely with the direction of interest rate changes, so the direction of the rate change will cause the price to move up or down in the opposite direction.

Credit quality is reflected in the yield and return, with lower-rated bonds having a greater risk and thus higher yields. Overall economic conditions play a role as well. Spreads between higher- and lower-rated bonds are narrower during better economic conditions and become wider as uncertainty increases. AAA/AAa is considered the highest credit rating, while ratings of C and D are given to bonds in default. It is not unusual for bonds in lower-rated funds to be backed with assets such as mortgages, auto loans or credit card receivables.

Why should investors consider high-yield bonds for their portfolios? Besides offering a better yield than investment-grade corporate bonds, the benefits include overall portfolio diversification along with potentially higher capital appreciation. A bond’s price may be bolstered as an issuer’s credit quality recovers.

Risk & Return With High-Yield Bond Funds

We used the A+ Investor Mutual Fund and ETF Screeners to create the list of mutual funds and ETFs depicted in Tables 1 and 2. Selected funds offer everything from broad exposure to specific strategies such as fallen angels and global diversification. The rest of this article looks at risk, return, credit quality, A+ Investor grades and performance of these funds.

Download the Excel spreadsheet of this table.

Lending perspective to the analysis of specific funds, important risk and return measures are highlighted in the tables. Since some ETFs do not yet have a five-year performance record, both tables depict one-year and five-year returns to provide a basis for comparison. Lacking historical data, funds less than one year old were screened out. Five-year returns emphasize intermediate-term performance and, importantly, both falling- and rising-interest-rate environments. Fund longevity is important to allow comparison across multiple interest rate and economic environments.

Download the Excel spreadsheet of this table.

Our screens capture three risk measures shown in the tables. The total risk index compares the standard deviation of returns for a given fund with that of all funds in the universe—bond, stock, domestic, international and alternative asset classes. The average risk index is 1.00. A value below 1.00 indicates lower risk relative to the overall universe. The category risk index compares the standard deviation of returns for individual funds and ETFs with that of peers from the same category. Again, the average risk index value is 1.00. Total and category risk figures are based on monthly returns for the last three years; ETFs in Table 2 without enough history will be missing risk index data.

Finally, beta is a measure of sensitivity to market movements, and 1.00 is the beta of the overall market. Morningstar applies a unique spin on this by comparing a fund’s excess return over Treasury bills to the market’s excess return. Beta is calculated using monthly returns for 36 months, which again explains missing data for some ETFs in Table 2.

Suppose a fund has a beta of 0.70. This indicates that a fund’s excess return is expected to perform 30% worse than the market’s excess return during up markets and 30% better during down markets. Conversely, a fund with a beta of 1.13 will experience 13% better excess returns during up markets and 13% worse in down markets.

High-Yield Bond Mutual Funds

The Fidelity Capital & Income fund (FAGIX) led the mutual fund pack with the highest five-year annual return at 4.8%. Investors paid for this return in the form of higher risk. Fidelity Capital & Income had the highest total risk, category risk and beta with values of 0.78, 1.25 and 1.26, respectively. In fact, the fund’s category risk grade is F. Yields range from 2.1% to 7.5% for the high-yield fund group, and Fidelity Capital & Income’s yield is 4.7%. Its large number of holdings (811) suggests diversification, but 13.9% of the portfolio is clustered in the top 10 holdings. Expense ratios range from 0.13% to 2.74%, and Fidelity Capital & Income’s expense ratio of 0.67% is graded at B.

Osterweis Strategic Income fund (OSTIX) has the lowest total risk index of 0.41. This means Osterweis Strategic Income has been less than half as volatile as the average fund. Its category risk index of 0.65, equivalent to a grade of A, reflects the lower overall risk of the high-yield category. The fund’s beta is 0.70 and its yield is 4.6%, which is just shy of Fidelity Capital & Income’s yield. Notably concentrated, 19.7% of the portfolio is in the top 10 holdings. Osterweis Strategic Income’s five-year annual return of 2.9% is significantly less than that of Fidelity Capital & Income, and investors will pay a higher 0.84% expense ratio, which garnered a C rating.

We use Morningstar’s average credit quality. Both funds have an average credit quality grade of B, putting their holdings on even footing in this regard.

High-Yield Bond ETFs

On the ETF table, the iShares Fallen Angels USD Bond ETF (FALN) chalked up the highest five-year annual return at 3.7%. Again, this higher return comes with higher risk. Its total risk index of 0.82 is the second-highest value for these high-yield bond ETFs that had enough data to calculate the figure. Not surprisingly, a grade of F was assigned to its category risk index of 1.38. Its beta is 1.37, putting iShares Fallen Angels in third place of the funds with enough data to calculate beta. The iShares International High Yield Bond ETF (HYXU) had the highest category risk index of ETFs reporting this figure, at 1.46.

iShares Fallen Angels’ yield of 5.1% falls in the middle of the yield range, which is 0.6% to 8.1% for the group of high-yield bond ETFs. Portfolio concentration is on par with the mutual funds discussed, with 15.0% invested in the top 10 holdings. The average credit quality rating for the ETF’s 261 holdings is BB. Its 0.25% expense ratio corresponds to an attractive A grade.

Further examining the risk/return trade-off, the ETF with the lowest total risk index and a five-year annual return figure is the Invesco Global Short Term High Yield Bond ETF (PGHY). In this case, the fund has an F grade for its five-year return of only 1.2%. Values for its total risk index, category risk index and beta were 0.38, 0.63 and 0.39, respectively. Its lower category risk index is in stark contrast to that of iShares Fallen Angels. Invesco Global Short Term High Yield earned an A for this measure. Its yield is 5.2%, a notch higher than iShares Fallen Angels’ yield. Out of a total 525 holdings, 9.6% of the portfolio is concentrated in the top 10 holdings, which is significantly lower than that of iShares Fallen Angels. Its expense ratio of 0.35% is higher than iShares Fallen Angels’ expense ratio and rates a B. Invesco Global Short Term High Yield’s portfolio has an average credit quality rating of B.

Apples to Apples?

The mutual funds and ETFs examined in this article through the lens of a risk/return trade-off have diverse strategies in niche areas of the high-yield bond market. First, we looked at the highest performers and their associated risk profiles. Then, we focused on funds with the lowest risk profile to see how returns were affected.

First movers (funds with the oldest inception dates) have extensive histories for evaluation, but in this case they lagged in performance. The Northeast Investors Trust fund (NTHEX), which was incepted in March 1950, has the worst five-year annual return at –0.3%. State Street’s SPDR Bloomberg High Yield Bond ETF (JNK), incepted in November 2007, lags in this same time frame with a 1.9% return.

In the high-yield bond category, returns average 2.3% for mutual funds and 2.2% for ETFs over the past five years. Comparatively, the average five-year annual return is 1.0% in the corporate bond category representing investment-grade assets for both ETFs and mutual funds.

Average expense ratios are 0.95% for mutual funds and 0.43% for ETFs in the high-yield bond category. Taxable corporate bond funds offer slightly lower expense ratios with averages of 0.18% for ETFs and 0.72% for mutual funds.

Investor Takeaways

Investors should weigh higher yields and overall portfolio diversification against the higher credit and default risks of high-yield bond funds.

Funds with a better average credit quality may offer less volatility and default risk but may not provide the sought-after level of capital appreciation and income. Returns and expense ratios should be evaluated with an eye to receiving the highest return at the lowest expense. Modest durations imply less of a decline when interest rates increase. Higher concentrations of holdings can signify a high-conviction approach but could present risk.

Understanding how a fund is constructed and the average credit quality of its components, along with additional risk measures, should provide more data points for appropriate evaluation. Finally, owning high-yield bonds in either mutual funds or ETFs simplifies the experience of selection and purchase, making it easy for individual investors to gain exposure.

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