Bonds are leaning into the double headwinds of rising interest rates and rising inflation. The high-yield end of the market is also struggling with mega-downgrades and troubling bankruptcies. Those events have prompted advisors to begin searching for replacements.Junk bonds for one, looked pretty good as the year began. However, the bonus over treasuries was not enough to cushion the fall. "Early in the year, high-yield bonds were priced to perfection," said Scott Berry, CFA, high-yield bond fund analyst at Morningstar. "That's why the drops in high-yield prices have come down as much as the treasuries."

The downgrades at General Motors and Ford added nearly $500 billion of supply to the market in the spring. Consistent increases of the discount rate by the Federal Reserve put the entire fixed-income market on watch. Higher energy costs and further pressure on the auto sector with Delphi's massive bankruptcy filing kept high-yield analysts working overtime. The newly issued bonds also burdened general credit quality this year.

"Lots of junk bond managers are concerned that the new issues coming to market don't have the quality they would like," said Berry. "Three years ago, issuers were focusing on cleaning up the balance sheet and improving cash flow. Now the focus is on shareholders and growing earnings with increasing leverage."

Noted financial advisor Mitchell Freedman isn't worrying about the downgrades and bankruptcies. He remembered waking up that morning in June 1970 to the news that Penn Central Railroad had declared bankruptcy, to everyone's surprise.

"That sort of news has always been with us," said Freedman. "But I'm much more concerned about the impact of all the accounting scandals on the fixed-income market than I am the ratings downgrades."

While Freedman isn't giving up on his high-yield holdings, he's looking at venturing into new fixed-income assets.

"For the first time, I'm looking at international fixed-income, including emerging market bonds," said Freedman, CPA/PFS, of the Mitchell Freedman Accountancy Corp., in Sherman Oaks, Calif. "At this point in time, I'm expecting a low earnings environment for a long time. I needed another way to reduce overall portfolio volatility."

Freedman's clients' portfolios average around 5 percent in high-yield bonds. He doesn't expect that to change. "In most cases, yield isn't that important to my clients," he said. "Their portfolios are structured to provide what they need, so fixed-income assets are in the portfolio just to dampen volatility."

The appeals of floating

Morningstar sees cash flowing into funds holding bank loans. Often called "floating rate" funds, these funds currently run yields around the high 3 percent range. "Investors can still get higher yields with bank loan funds," said Berry. "These holdings are lower-quality issues like junk, but have the added safety of being secured by assets and being senior debt of the issuers."

Bank loan funds' interest rate floats with the market, usually tied to LIBOR. Besides lower default risk than high-yield funds, the floating rate changes the interest profile of the asset as well. "Adding these funds can balance out the interest rate risk in a portfolio," said Berry.

Investors seeking yield are also increasing investments in high-yield municipal funds. The muni market is helped by healthier tax receipts helping to lower the incidence of defaults. Berry also pointed to funds, such as Franklin Income, that, while only holding 40 percent bonds, sport a yield of 6 percent. "The fund invests in a variety of securities like utilities," said Berry. "They're looking for income wherever they can find it."

Inflation-protected bonds like TIPS are showing up in portfolios at Norwalk, Conn.-based Schwartz & Hofflich for the first time. "Within the last six months we've begun to use a small percentage of inflation-protected bonds," said S&H's Ann D. Jevne, CPA, PFS, CFP.

Jevne's clients' fixed-income holdings got shorter recently as well. As interest rates rose, maturities for most holdings shrank to three to six months. "Some clients are sitting in seven-day commercial paper," said Jevne.

The firm also goes to preferred stocks for a little yield, but has moved out of them entirely right now. With preferreds, their major criteria is quality. Sticking with quality is why S&H never buys high-yield. "We don't intentionally purchase junk bonds," says Jevne. "If some become junk, we update our analysis and decide whether to keep issues on an individual basis."

Jevne takes advantage of the market volatility to increase yield as well. "We do go into the market to grab issues with higher yields," she said. "Earlier this year, we grabbed some issues that the market hasn't matched yet in yield."

The advantages of funds

Advisors can buy junk bonds directly, but buying through mutual funds has its advantages. "There's no question that in the high-yield area funds have advantages over individual bonds," Berry said. "In addition to being able to get diversification of these riskier assets, investors have a full-time staff analyzing new purchases and tracking holdings for changes in quality."

Criteria for choosing the best of the funds include the standard items of significant manager tenure and high Morningstar ratings. "With high-yield funds, I also choose by current yield," said Freedman. "Right now I'm using a fund with a healthy 6.59 percent current yield."

Junk funds offer less in the way of current yields and possibility for capital appreciation. But as a diversification tool, the high-yield funds seem to still have a place. "The corporate bond market still makes sense with the relatively low rate of defaults and a reasonably healthy economy," said Berry.

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