High yield bond funds can accomplish a great deal when it comes to generating income from a retirement account. However, to take advantage of what they have to offer, investors need to ramp up their basic understanding of what this particular investment category entails.
Right now, many high yield bond funds are getting pummeled because some are loaded up with as much as 25 percent of their loans in coal and petroleum industries. These bonds, while in jeopardy perhaps, have yet to actually go into default. Instead, the perception that they may default has driven down their values in the bond market. Like the stock market, the bond market is a "voting machine" with values based on what investors perceive to be current and future values. The immediate values of the actual bonds are determined by the "weighing machine" that is based on the borrowers’ balance sheets and income statements. Energy companies in recent years have made huge amounts of money and they would have to lose all of that equity before their bond values ultimately take a hit.
None of this is a problem for long term holders of the more conservative high yield bond funds. It’s like the policeman at a crime scene who suggests to gawkers, "Move along folks. There’s nothing to see here."
According to Morningstar, too many investors think they can move in and out of high yield bond funds in an effort to successfully time that market. Statistics that track the inflow and outflow of money into these funds indicates that, as a group, investors gave up 32 percent of what would have been their overall yield throughout the past ten years. This is the same statistical analysis that, when applied to the stock market back in 1999, illustrated that the average mutual fund investor had earned just 3 percent per year for twenty years while the total stock market had earned an annual 16 percent over the same period. Whether in stocks or bonds, chasing last year’s best performers and/or trying to second guess what will happen next is always a mistake when compared to a buy and hold approach.
In the six years since 2008, about $1.9 trillion of high-yield bonds have been issued with 15 percent of those bonds consisting of loans to energy companies. All that leverage was what made energy companies such hot performers in the stock market until recently, but living by the sword means dying by the sword. Leverage works both ways.
More conservative high yield bond funds stayed away from the energy sector as their managers showed more contrarian restraint and avoided the temptation to move with the herd. For buy-and-hold investors focused totally on just the monthly income, allocating a portion of a retirement account in high yield debt can be rewarding with current yields of approximately 5 percent. Also, the better funds have relatively short maturities averaging about five years. Fund managers are making relatively short-term bets which means that there are fewer unpleasant surprises than they might otherwise confront if they have bonds what will extend to, say, ten years before the borrower has to pay the principal back. Peering that far into the future requires more clairvoyance.
The bottom line for bond fund investors is to focus on the amount of money deposited each month into a checking account while ignoring any fluctuations in capital value. Those periodic downdrafts are only losses on paper unless you’re an investor who freaks out and bails out at that inopportune moment.
Readers may also note that my columns have been conspicuously absent of specific fund recommendations over the past year. This is because both the SEC and FINRA consider these columns to be advertising if a stock or fund is mentioned. Consequently, the mention of a security requires an immediate disclaimer ("past performance is no guarantee of future results," etc.) along with a comparison of the fund’s performance against some benchmark. Obviously, this would defeat the flow of information and detract from the overall message. Any reader, however, is free to reach out to me at the contact information provided below and I can answer specific questions without running afoul of investor protection regulations.