By Elizabeth O'Brien

Retirees may be reaching for yield as rates notch lower on money-market funds and other safe accounts. High-yield "junk" bonds offer attractive income and aren't a bad idea -- just don't overdo it.

Junk bonds currently yield 7.2%, more than double the 3.4% of the broader U.S. bond market, comprised mostly of Treasuries, investment-grade corporate debt, and mortgage-backed securities. "That's a pretty healthy coupon to clip right now," says Garrett Melson, a portfolio strategist at Natixis Investment Managers Solutions.

The bonds are called "junk" because they're rated below investment grade by credit-rating firms, due to higher risks of default or downgrades. Companies that issue them usually have problems, like high debt levels relative to income. They're among the first to show signs of distress in a slowing economy, and investors in the space closely watch default rates for signs of trouble.

By some measures, there isn't much value in the junk universe. The difference -- or spread -- between junk bonds and risk-free Treasuries, though healthy, is tight by historic standards, meaning that investors aren't being compensated as much for taking on the additional risk of investing in high yield.

The bull case is that the economy looks healthy. Many pros are hopeful that the Federal Reserve will deliver a "soft landing" -- taming inflation without tipping the economy into a recession. Economists forecast GDP growth of around 2% this year and next, far from recession territory.

What's more, investors aren't observing the kinds of excesses that preceded prior crashes -- things like the leverage that contributed to the telecom bust of the early 2000s, says JoAnne Bianco, investment strategist at BondBloxx, a provider of fixed-income exchange-traded funds. "Right now, we're in a strong environment for fundamentals," she says.

Assuming defaults don't spike, the relatively narrow spreads in junk should hold up, the thinking goes. Investors would then be likely to capture returns close to the current yields on the bonds.

Still, some advisors aren't sold on junk bonds. "If I'm not getting a significant premium over risk-free Treasuries, is the juice really worth the squeeze?" says Bryson Roof, a certified financial planner at Fort Pitt Capital Group in Harrisburg, Pa.

Roof prefers to take on risk through clients' stock allocation and uses bonds to reduce portfolio risk. He is currently making five-year ladders of investment-grade bonds for his clients.

For those who do venture into junk territory, tread carefully. No advisor would suggest that high-yield become a core bond position. "We like to call them the 'plus' in a 'core-plus portfolio," Bianco says.

One way to reduce some risk is to stick with the higher-rated arena of the junk universe, which would be bonds rated BB, or Ba by Moody's. They have a long-term default rate of 1%, versus 4% for high-yield bonds overall, according to Moody's. ETFs like iShares BB Rated Corporate Bond (ticker: HYBB) and BondBloxx BB-Rated USD High Yield Corporate Bond $(XBB)$ offer easy exposure.

The VanEck Fallen Angel High Yield Bond ETF $(ANGL)$ holds bonds issued by companies that were initially rated investment grade but fell into junk territory; it's a relatively high-quality portfolio within the universe and has returned 6% on an annualized basis over the past decade against a 3.1% return for the high-yield market. The ETF yields 6.3%.

How much of your bond portfolio should be in junk? One way to consider that might seem paradoxical: The higher your fixed-income allocation, the more you can dip into high-yield, Melson says.

For example, a retiree with a classic portfolio of 60% stock and 40% bonds would probably want to take on risk primarily through stocks, and use bonds for ballast. In that scenario, about 80% of the bond portfolio could be in Treasuries and 20% in corporate bonds, with a smaller portion within that allocated to high-yield, Melson says in one illustration.

By contrast, a portfolio that's 30% stock and 70% bond could have a 30% allocation to corporate bonds, with an allocation to lower-rated bonds within that, he notes.

Melson favors active management within high yield. "It's not so much about picking winners as avoiding losers," he says.

One actively managed option is the BlackRock Flexible Income ETF $(BINC)$, which invests in a range of fixed-income securities, including high-yield debt. It's up 5.6% this year and yields 5.7%, a healthy gain in a tough bond market.

Write to Elizabeth O'Brien at elizabeth.obrien@barrons.com

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October 10, 2024 01:30 ET (05:30 GMT)

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