NEW YORK (TheStreet) -- Since the financial crisis, high-yield bonds have soared. During the past three years, high-yield mutual funds returned 16.3% annually, according to Morningstar. Can the rally continue? Probably. High-yield bonds yield 7%. That is a tempting payout at a time when 10-year Treasuries yield 1.73%.
But high-yield bonds -- which are rated below-investment grade -- can drop sharply when investors sour on the outlook for the economy. To limit risk, consider strategic income funds. Besides high-yield bonds, the funds hold a mix of high quality and international issues. Portfolio managers change allocations as market conditions vary.
Top fund managers have proven deft at shifting holdings, emphasizing high-quality bonds in difficult times and increasing high-yield holdings to take advantage of rallies. During the turmoil of 2008, many of the strategic income funds managed to limit losses by emphasizing high-quality bonds, which stayed in the black. The best managers have surpassed both the average high-yield fund and the Barclays Capital Aggregate bond index. Strong performers include Federated Strategic Income STIAX , Franklin Strategic Income FRSTX , and John Hancock Strategic Income JHFIX .
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During the past 10 years, the Federated fund returned 8.2% annually, outdoing the average high-yield fund by 1 percentage point and topping the Barclays Capital Aggregate bond index by 2 percentage points. While many strategic income funds keep about one third of their assets in high yield, Federated takes a more aggressive stance. When the portfolio managers have a neutral outlook on the markets, they hold 40% of assets in high yield. The approach has enabled the fund to excel in rallies.
Federated currently has 44% of assets in high-yield bonds. Portfolio manager Joe Balestrino says that the outlook for high-yield issues remains solid. The annual default rate is less than 2%, well below the historical averages. Defaults should remain under control since the economy is growing and balance sheets remain strong. "The economy is out of the woods," Balestrino says.
In their neutral position, the Federated managers keep 25% of assets in emerging markets bonds. The fund currently has 31% of assets in the sector. Balestrino says that BBB-rated emerging market bonds yield about 5.5%, compared to a yield of only 3.8% for similar bonds in the U.S.
Investors seeking a tamer choice may prefer Franklin Strategic Income. During the past ten years, the fund returned 7.9% annually. Franklin typically has between 20% and 40% of assets in high-yield bonds. The allocation last dipped near the low end of the range in 2007 and early 2008. At the time, confident investors had little concern about defaults, and they bid up prices of shaky issues. As a result, high-yield bonds only yielded 300 basis points (3 percentage points) more than Treasuries. By shifting away from high yield, Franklin limited losses in 2008 and outdid most of its peers. The fund now has 28% of assets in high yield.
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Franklin has 18% of assets in floating-rate loans. Those yield about 5.5%. The floating issues are loans made by banks to companies with below-investment grade credit. Because the loans are senior secured debt, they are considered safer than high-yield bonds. In the event of a default, owners of loans are paid before high-yield bond investors receive anything. If interest rates rise, the yields of the floating-rate issues adjust upwards. That helps the bank loans to be resilient during periods when most other fixed-income assets are sinking. "Bank loans tend to be more stable than high-yield bonds," says Eric Takaha, a Franklin portfolio manager.
Another fund that performed well in 2008 is John Hancock Strategic Income. During the past ten years, John Hancock returned 7.8% annually. A year and a half ago, the fund had more than 40% of assets in high-yield bonds. Since then the portfolio managers have lowered the allocation as prices appreciated. Now the fund has 34% of assets in the sector.
John Hancock has been increasing its stake in emerging markets bonds, which now account for 25% of assets. Portfolio manager Dan Janis especially likes bonds from emerging Asian countries, including Singapore, Malaysia, and the Philippines. The Asian economies remain healthy as domestic consumption increases. While credit rating agencies have downgraded the U.S. and European countries, many of the Asian economies have been getting stronger. "Indonesia has been upgraded every year for the last three years, and the Philippines is in the process of being upgraded," says Janis.