Some riskier income funds yield more than 8%. Just the time for investors to be vigilant

Published Tue, Oct 10 20232:16 PM EDT

High yield bond funds tout sweet yields, but swirling concerns around the economy are spurring questions on how much longer the income party will last. Investors have been enjoying higher yields on fixed income since the Federal Reserve embarked on its policy-tightening campaign in March 2022. You don't have to stretch much for yield – after all, the 3-month Treasury is yielding 5.5% – but those who do have been rewarded thus far. Consider that the 30-day yield on the SPDR Bloomberg Short Term High Yield Bond ETF (SJNK) is 8.78%. Indeed, the Morningstar U.S. high yield bond index has a year-to-date total return of 4.61%, compared to the -1.29% total return on Morningstar's U.S. corporate bond index . The total return on the SPDR Bloomberg Short Term High Yield Bond ETF is even better, at 5.79%. High yield bonds are non-investment grade issues, meaning they're rated below BBB, and they have a higher default risk versus their investment-grade counterparts. "If you look at an 8%, 8.5%, 9% yield on a fund or an index, that's an attractive yield versus what they have been used to in the past," said Paul Olmsted, senior manager research analyst, fixed income, at Morningstar. He noted a solid chunk of the total return seen in high yield today stems from coupon income. "There is risk here, that risk of lower rated debt and increasing defaults going forward is there," Olmsted said. A tougher economic outlook UBS senior credit strategist Alina Golant in a report last week highlighted three key factors behind high yield's outperformance this year: A stronger-than-anticipated U.S. economy, robust fundamental factors for high yield – including longer-dated debt that was refinanced at rock bottom coupons – and low new issuance. However, that picture could change as issuing companies grapple with the prospect of a slowing economy. "On the negative side, the economy may be slowing driven by a weakening consumer with depleted savings, student loan repayments and high interest rates," Golant wrote. "Additionally, we expect worsening corporate credit metrics due to the upcoming refinancing needs." Consumers are also a focal point when it comes to the economic outlook, according to Peter Higgins, head of fixed income and senior fixed income portfolio manager at Shelton Capital Management. "Our take is that this is going to be a harder landing, and for us the consumer is the catalyst," he said. "The consumer is still strong because they are employed, but wage growth is slowing." The latest nonfarm payrolls report showed that average hourly earnings were up 0.2% in September and gained 4.2% from a year ago. That compares to economists' respective estimates for 0.3% and 4.3%, according to Dow Jones. Being selective about risk UBS is neutral on high yield overall, but positive on short-dated high yield paper of good quality companies. "These bonds need to be refinanced between now and 2026, trade below par, and offer good carry," said Golant. She added that there are also idiosyncratic opportunities in the form of companies that may get upgraded to investment grade, but haven't yet fully priced that in. Shelton's Higgins noted that fund managers are incentivized to go for higher quality, even within the realm of high yield – in particular, picking BB-rated issues, just below investment grade. "[These companies] also need some kind of special product or a niche offering that can drive further revenue growth and margin expansion, and it's tough to do that in a weakening economy," he said. "We have moved up in quality in high yield, and we are straddling that BBB and BB average weighting." Just as fund managers need to be selective about choosing individual issues as the economy faces hurdles, investors also should be picky about how they tap the high yield market. The asset class can complement a core bond portfolio, even as it brings higher risk – and that might require a more hands-on approach. "This might be my opinion, but I prefer active managers here, and the reason for that is in periods like this, they'll speak with management teams, look at corporate fundamentals and hopefully avoid big losses or big drawdowns that can occur," said Morningstar's Olmsted. -CNBC's Michael Bloom contributed reporting.