If you want to build a diversified portfolio of income-generating investments, you'll need high-yield bond funds to complement your dividend funds.
When searching for high-yield bond funds, just be sure you're not only looking for the highest yields. There are other qualities to consider when looking for the best funds to buy.
- Consider adding high-yield bond funds to your portfolio of investments that generate income.
- Because of low credit ratings, high-yield bonds come with risks and potentially high rewards.
- Factors to consider when choosing high-yield bond funds include type of account, tax bracket, risk tolerance, and your other holdings.
- Several investment brokerages offer these funds including Fidelity, T. Rowe Price, and Vanguard.
What Are High-Yield Bonds?
Also known as junk bonds, high-yield bonds are bonds that pay higher yields because of low relative credit ratings. More specifically, the bonds, or the entities issuing the bonds, have credit quality ratings below investment grade (a rating below BBB by Standard & Poor's or below Baa by Moody's credit rating agencies. AAA is highest). A bond can receive a lower credit rating because of the risk of default on the part of the entity issuing the bond.
Therefore, because of this higher relative risk, the entities issuing these bonds will pay higher interest rates to compensate investors for taking the risk of buying the bonds, thus the name high yield.
Think of a personal credit score. Borrowers with poor (lower) credit scores generally pay higher interest rates on their loans or credit card balances than borrowers with good or excellent credit. It's the same concept with the issuing entities of bonds, which can be corporations, publicly-owned utilities, and state, local, and federal governments.
How to Choose the Best High-Yield Bond Mutual Funds
Before buying high-yield bond funds, or any other investment, there are a handful of considerations to make during the research and analysis phase.
Here are some of the key points or criteria for choosing the best high-yield bond funds:
Type of Account
If the fund will be held in a taxable account, consider buying a high-yield municipal bond fund, which will produce income that is tax-free at the federal income level. Taxable income is not a consideration for tax-deferred accounts, such as IRAs and 401(k)s because the income is not taxable to the investor while the high-yield bond fund is held in the account.
Tax-free bond funds are especially beneficial for investors in higher tax brackets, where minimizing taxable income is likely a higher priority, as compared to investors in lower tax brackets. To measure the benefit of using tax-free bond funds, investors can calculate the tax-equivalent yield, sometimes called the tax-effective yield.
Tax-equivalent yield = interest rate ÷ (1 – your tax rate)
High-yield bond funds can have stock-like returns, meaning performance can average higher than conventional bond funds. However, declines can be more severe. Bottom line: If you're not OK with volatility in price, high-yield bond funds may not be the best choice for you. A better consideration may be a bond index fund like the Vanguard Total Bond Market Index Admiral Shares (VBTLX), which tracks the Bloomberg Barclays US Aggregate Bond Index.
Other Portfolio Holdings
Although high-yield bond funds are higher in market risk than conventional bond funds, they may fit in well with a diversified portfolio of mutual funds. For example, if you already have a bond index fund, as well as a variety of stock funds, a high-yield bond fund could be a good complement that adds diversification to your portfolio.
Best High-Yield Bond Funds
Since there is no one-size-fits-all high-yield bond fund, we highlight ten standouts that can be a fine addition to complement a diversified portfolio.
In no particular order, here are our top choices for high-yield bond funds:
Vanguard High-Yield Tax-Exempt (VWAHX)
If you're looking for high yields and want to minimize taxable income with a low-cost, no-load mutual fund, VWAHX may be the best fit for your needs. The portfolio consists of more than 2,000 municipal bonds, which are tax-free at the federal level. The 30-day SEC Yield for VWAHX is 1.39% as of July 15, 2021, and the expense ratio is just 0.17% or $17 for every $10,000 invested. The minimum initial investment is $3,000.
Vanguard Long-Term Investment Grade Bond (VWESX)
Along with high yields, investors should expect higher market risk, compared to the average bond fund. However, VWESX has a good combination of high yield and lower relative risk compared to the junkiest of bonds. Long-term bonds generally pay higher yields than short- and intermediate-term bonds and the average credit risk for bonds in VWESX is just slightly below investment grade credit quality. The 30-day SEC yield as of July 15, 2021, for VWESX is 2.49%, the expense ratio is just 0.22%, and the minimum initial investment is $3,000. Caution on long-term bond funds: The interest rate risk is higher than bond funds that hold bonds of lower average duration. Translation: Prices could fall in a rising interest rate environment; however, long-term performance is expected to be higher than shorter duration bond funds.
T. Rowe Price Corporate Income (PRPIX)
Another top bond fund that pays decent yields without taking on too much credit risk is PRPIX. Also, being an intermediate-term bond fund, PRPIX doesn't carry as much interest rate risk as long-term bond funds. Combine these top qualities with low expenses (0.61%) and you have one of the best high-yield bond funds to buy. The minimum initial investment for PRPIX is $2,500.
Fidelity High Income (SPHIX)
If your highest priority is yield, SPHIX is a good choice. The current yield of 3.71% is among the best for bond mutual funds, and the expense ratio of 0.72% is reasonable. However, the credit quality of most of the holdings is below investment grade. Therefore, if you're looking for a good junk bond fund, SPHIX is definitely worth a look. There is no investment minimum.
Fidelity Short Duration High Income (FSAHX)
Investors wanting high yields but low-interest rate risk will want to take a look at FSAHX. The low credit quality creates its own market risk but the trade-off is a high yield (2.72%) and the short-term average duration minimizes interest rate risk, which is especially pronounced in a rising interest rate environment. Expenses for FSAHX are 0.75% and there is no minimum initial investment.
Fidelity Capital & Income (FAGIX)
This fund is unique in the high-yield space in that it allocates a portion of assets (about 20%) to dividend stocks. This exposure to equities adds a bit of market risk but it can also juice performance over time. The current yield for FAGIX is 2.52% and the expense ratio is 0.68%. There is no minimum initial investment.
Vanguard High-Yield Corporate (VWEHX)
Investors looking for high yields and wanting to take the added risk to get them will like what they see in VWEHX. Most of the portfolio consists of bonds below investment grade but the yield of 2.87% and low expenses of 0.23% may be a happy trade-off for high-yield investors. The minimum initial investment is $3,000.
Vanguard Long-Term Corporate Bond Index (VLTCX)
If you love low-cost index funds and you want high yields, VLTCX should be on your shortlist for an addition to your portfolio. Although this fund is only available in Vanguard's Admiral shares, which means you'll need to meet the minimum initial investment of $3,000 to get started, the low expense ratio of just 0.07% and the current yield of 3.08% make this fund worthy of consideration.
California Long-Term Tax Exempt (VCITX)
Although VCITX is a state municipal bond fund, the income from the fund is free of tax at the federal level and at the state level (if you live in the state where the municipal bonds are issued). Municipal bond funds don't always offer the highest yields. But when you live in a state with high taxes, the state and federal combined tax-effective yield can be significant. The yield for VCITX is 0.98% percent. When you factor in the tax-equivalent yield, it climbs higher. Expenses for VCITX are 0.17% and the minimum initial investment is $3,000.
New York Long-Term Tax Exempt (VNYTX)
For the same reason VCITX can be a smart choice for high-yield investors in California, New York investors may consider VNYTX. Remember that the benefits of tax-exempt funds are only for taxable accounts. The yield for VNYTX is 1.08% percent and the combined tax-equivalent yield for most New York residents would be higher. The expenses for VNYTX are 0.17% and the minimum initial investment is $3,000.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.