Bond fund investors have been worrying about two things recently: interest rates and the economy. If the Federal Reserve starts lifting rates, which have sunk to rock bottom levels, it could hammer interest-sensitive government bond funds. And if the economy tanks, it could cause worries about corporations and their ability to pay off their high-yield obligations, making high-yield bonds risky.
Morningstar senior analyst Bradley Sweeney reasons that in this environment, the scales tip slightly in favor of high-yield funds. The reason: A shrewd portfolio manager should be able to shield a fund from credit-quality woes, even in the thorniest of times, whereas a sharp rise in rates will clobber government bond portfolios run by the best of minds.
It helps that junk bond funds have enjoyed an impressive run. From the beginning of 2003 to April 21, the average high-yield portfolio was up 7.7%, according to Morningstar, compared to 1.5% for the average intermediate-term bond fund, and 1.9% for the Standard & Poor’s 500. Sweeney says investors can thank two things for the rally. First, the market unduly punished high-yield bonds last year when companies such as Qwest and Georgia Pacific received junk bond black marks from rating agencies. “The feeling then was that a lot of companies might have trouble meeting their obligations,” says Sweeney. Investors acted too swiftly on concerns, and soon junk bonds were priced too cheaply in the eyes of market experts.
The second factor stems from the meager amount of interest paid out by other higher-rated bonds. Earlier this year, for instance, the 10-year Treasury offered up dividend yield of a paltry 3.9%. Junk bonds, meanwhile, have boasted yields twice that figure or greater.
Morningstar’s Sweeney says investors should look for funds that keep a tight rein on expenses and whose management has experience through the peaks and troughs of the market cycle. With that guidance, we screened Morningstar’s database to bring up a handful of good, high-yield performers. Although the average high-yield fund expenses about 1.3% of its assets, we looked to better that by limiting our sights to funds with a 1.0% ratio or less. We ranked them by three-year average annual total return.
Top honors among the 6 funds we selected went to the Neuberger Berman High Income Bond Investors fund (NBHIX). The fund has provided investors an average of 7.68% yearly return and has a solid five-year track record as well, with a 5.38% mark. The fund also seems to hold fees in check with an expense ratio of 1.0%. Taking a relatively conservative approach, a large slice of Neuberger was placed in higher-rated bond offerings, which can help shield investors if the economy remains anemic.