Stable Income Opportunities in High-Yield Debt

Since the financial crisis of 2008 and the ensuing recession in the United States, the U.S. Federal Reserve embarked on an unprecedented course of extremely easy monetary policy. In an attempt to rescue the U.S. economy from the worst recession since the Great Depression, the U.S. central bank lowered short-term interest rates, under the Fed Funds rate, to zero. In addition, the Federal Reserve conducted a series of monthly bond purchases, designed to keep long-term rates low as well. The overarching goal of these programs was to prove that the Federal Reserve would do everything in its power to keep the economy out of recession.

Rising Asset Prices, Falling Yields

The result of these actions was a steep decline in bond yields, and consequently a massive lift in bond prices. This is particularly true as it pertains to the low end of the credit spectrum. High-yield bonds, often referred to as “junk” bonds because of their below-investment-grade status, have rallied considerably since the Federal Reserve began its policy of aggressive monetary accommodation.

And high-yield bond funds have enjoyed robust inflows since investors are attracted to the high yields in a low-rate environment. To that end, net high-yield bond inflows totaled $236 million in the week ended September 16, according to Lipper. That was a significant increase from a $185 million net inflow the previous week.

Why High-Yield Bond Funds Are Attractive

It is understandable why investors would flock to high-yield bond funds. With interest rates still at historic lows, many high-yield bond mutual funds offer attractive yields. For example, the Fidelity High Income Fund (SPHIX) currently yields 5.5%, far higher than the 10-Year U.S. Treasury Bond, which yields 2.1%. Another high-yield bond fund example is the BlackRock High Yield Bond Portfolio fund (BHYAX) which offers a 5.2% yield. High-yield funds offer above-average yields, even when compared to other forms of corporate bonds.

Moreover, bond funds are an optimal choice over selecting individual fixed-income securities as a means of diversification. Owning a basket of bonds is a great way to spread risk around. This is especially true for bonds that are not investment grade as the individual issuances involve a higher level of risk than a diversified mutual fund.

Another advantage of investing in high-yield funds is that corporate balance sheets are healthy. Cash levels are rising, as are corporate profits, thanks largely to the steady global economic recovery in the past several years. This has led to reduced levels of corporate defaults, even among riskier issuers. Defaults are well below the long-term averages. According to Fitch Ratings, U.S. corporate bond defaults remain at a relatively low 2.9%.

The Bottom Line

Since the Federal Reserve began its unprecedented policy of extreme monetary accommodation and quantitative easing, income investors are starved for yield. Government bonds pay very little in interest, and traditional income-generating products, like bank certificates of deposit, offer almost nothing in yield. Even corporate bond funds are not much better.

In response, investors have flocked to high-yield funds. These funds offer the benefit of diversification which helps reduce risk. And corporate defaults remain low. If the U.S. economy continues to improve, and corporate profits continue to rise at a modest pace, defaults should continue to remain low. That should keep the relatively strong yields of high-yield bond funds attractive for income investors.

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