Expert: Doug Ingram - 6/14/2011

Question
What are the risks associated with high yield bond funds (like the one with Vanguard)? (1) If the Fed increases interest rates to fight inflation, will HY bond funds increase or decrease in value? (2) How closely related are HY bond funds to the stock market? If stocks go up, will HY bonds go up as well meaning that HY bonds are not a hedge for stocks at all? (3) If the worse case scenario happens on Aug 2 and the govt shuts down, will HY bond funds be affected or are they isolated from such due to being corporate bonds without govt bonds? Thanks for your help.

Answer
There are many risks, and probably more than I can cover.

Obviously, you have the primary risk from high-yield.  The company pays a higher yield because there is at least a question as to its ability to pay and service debt.

In a fund with a good name (which Vanguard has), you have diversity which spreads your risk around.  Each fund has its own managers and you are subject to their abilities and style.  I can't comment on that.

1)  Though not always the case for individual issues, if interest rates rise -  values drop.  It's a given with government bonds, but other factors affect corporate debt.  The net result should still be a negative.  However, if rates are rising because the economy is really improving, some corporate debt values could rise as their outlooks are upgraded.

2)  There is no real hedge from bonds versus stocks.  Sometimes they do better together, at others they move in opposite directions.  However, corporate debt can improve with a rising stock market and a healthier economy.  The reason investors mix bonds and stocks is for the safety and liquidity of bonds and the growth prospects for stocks.  Some of the safety and liquidity element goes away with high-yield debt.  HY debt is so named because you are being compensated for taking a much greater risk than with Treasuries and high-rated issues.


3)  The disaster scenario is a negative across the board.  All debt is priced at a spread to Treasuries.  (Rates up -- values down).  Even if a company has improving credentials, I can't see any good thing for ANY bonds with a U.S. government default.  I also think this scenario has a near-zero possibility.  The president can make sure government bond holders are paid by decree.