Morningstar

In high-yielding bond funds, where's the beef?

Twenty years ago, these fixed-income investments were pretty easy to understand. Nick-named "junk" because their portfolios were made up of low-grade and non-rated bonds, total returns on these funds could fly pretty high because of the lofty coupons on the bonds held in their portfolios. Today, their portfolios are still full of low-quality high-yielding bonds, but their performance can't be counted on.

What's messing that up? Odds are it's the equity market.

One reason pros tell folks to diversify among asset classes is to create a portfolio that adjusts to market conditions: When stocks aren't doing well bonds are supposed to be and visa versa. While that kind of thinking is generally considered a rule of thumb, there are exceptions---and today junk bond funds are one of them.

Look at Lipper's year-to-date performance numbers and you'll find corporate debt A-rated funds outperforming high-yielding " junk " bond funds by almost one percent: The average junk bond fund was up 1.2 percent through June 13, while the average corporate debt a-rated funds were up 2.1 percent. Over the last two years, corporate debt A-rated funds have returned on average, 9.5 percent while high yield funds less than one percent.Although that may be good news for the A-rated bond fund holder, it's got to be disappointing to the junk bond holder who's been expecting a lot of juice in return for the risk he or she has taken on by investing in low-quality bonds.

While the bond market is a complicated one, here are some things to consider if you're a high-yield bond investor puzzled by your fund's return:

--- Market Cycles. "The high yield market is kind of a funky market, " says Louise Rieke, portfolio manager of the Waddell & Reed Adv. High-Income fund, (UNHIX). "We're a hybrid."

Rieke explains that in different market cycles, the performance of high-yielding bonds either follows equities or it follows treasuries. "Right now everyone is focused on credit, so we're going to follow the equity markets. Then, when interest rates become the main focus, we'll focus on what treasuries are doing."

--- The equity market, interest rate and credit risk. "High-yielding investments, in general, are a bet on the equity side of the market, " says Andrew Clark, a Lipper senior research analyst specializing in fixed-income.

Clark reminds investors that the pricing of bonds is dependent upon two things--- interest rate risk and credit risk meaning that the direction of interest rates and the ability of the company issuing the bonds to make timely payments on its bonds impacts its pricing. So, if there's concern that the company might have difficulty making payments on its high-yielding debt, the price of the bond gets lowered.

Even when there's a hefty coupon on the bond, Clark says--- depending upon what's happening to the company's stock--- sometimes the bond's "coupon gets "overwhelmed."

--- Portfolio composition. Simple as it may sound, it's what in a fund's portfolio that counts the most whether it's an equity fund or a high-yielding bond fund.

The top performing high-yielding fund, through June 13, was Fidelity's Real Estate High Income fund,it was up 6.96 percent, and as it's name implies, invests in real estate investment trusts, REITS--- a sector of the market that's been performing well lately. Some sectors not performing well this year and found in many high-yielding bond portfolios include cable television, wireless or energy bonds in their portfolios.

Kevin Lorenz, one of the team managers on the TIAA-CREF High-Yield Bond Fund, (TCHYX), said that the whole high-yield market has come under pressure recently in a few different sectors. "Cable television, for one, has been impacted by Adelphia Communications, and the whole sector has traded down on fears and concerns."

Lorenz says investors need to take a look at what's in a high-yielding bond fund's portfolio before they invest, and, to make sure they look for funds that have well diversified portfolios. Then, they need to understand what they are investing in. "We think the asset class is one best suited for long-term investors who can ride out the short-term price volatility, "says Lorenz. "But people who think that high-yield is a high-yielding money market equivalent are vastly mistaken."

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Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.