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Should You Buy a Short-Term High Yield Bond Fund?

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The Basics of Short-Term High Yield Bond Funds

Investing is all about trade-offs. Based on their objectives and risk tolerance, investors can take on more risk to pick up extra returns, or sacrifice some returns in the name of safety. When a single investment can help bridge this gap, people take notice. It’s no wonder, then, that short-term high yield bond funds have begun to explode in popularity.

Short-term high yield bond funds typically invest in bonds that are rated below investment-grade and that have maturities of less than five years.

The Risk and Return Characteristics of Short-Term High Yield Funds

Short-term high yield bonds have grown in popularity because they help investors balance the two major types of risk: interest rate risk and credit risk

High yield bonds are on the riskier side of the bond fund risk spectrum since the bonds are issued by less creditworthy companies – meaning that they are more sensitive to adverse changes in their underlying business trends or unfavorable shifts in the economy. In other words, they have above-average credit risk. While the asset class tends to yield more than most market segments, its higher risk also makes it less appropriate for more conservative investors.

Short-term bonds, in contrast, tend to offer lower risk than their longer-term counterparts since they have less sensitivity to shifting interest rates. At the same time, they also offer lower yields.

Short-term high yield funds help balance these two considerations. While the funds feature lower yields than typical high yield funds, they are also less volatile due to their shorter maturities. Compared to a typical investment-grade corporate bond fund, they have both higher risk and higher yields. In this sense, they offer a middle ground between corporate bonds and high yield bonds (all maturities) on the spectrum of risk and reward.

Yield and Downside Potential vs. Traditional High Yield Funds

Here are some specific numbers: on August 1, 2013, the two largest high yield bond exchange-traded funds: the SPDR Barclays High Yield Bond ETF (JNK) and the iShares High Yield Corporate Bond ETF (HYG), had SEC yields of 5.57% and 5.25%, respectively. On the same date, the two largest short-term high yield funds, PIMCO 0-5 Year High Yield Corporate Bond Fund (HYS) and SPDR Barclays Short Term High Yield Bond Fund (SJNK), had yields of 3.62% and 4.63%, respectively. Keep in mind, these yields change every day – this is simply a snapshot to illustrate that short-term funds offer yields that are about three-quarters of their longer-term counterparts on average.

As of this writing, the two short-term funds don’t yet have three- or five-year numbers to illustrate their risk in comparison to the more established options. However, the performance results from the bond market sell-off in the second quarter of 2013 provide some clues. From May 8 to June 24, 2013, JNK and HYG produced total returns of -7.0% and -7.3%, respectively. In that same time period, HYS and SJNK returned -4.7% and -4.9%. This shows that shorter-term funds can be expected to have about two-thirds of the risk of longer-term products.

Who Should Own These Funds?

As the returns from May-June 2013 indicate, these funds – while lower-risk than broader high yield funds – certainly have more than their share of potential volatility. As a result, investors who can’t afford to lose money should look elsewhere. Ideally, an investor in these funds would have above-average risk tolerance and a time frame of at least three years.

Is Now a Good Time to Buy Short-term High Yield Funds?

Short-term high yield funds are a potentially attractive option in a rising-rate environment. While high yield tends to have less sensitivity to prevailing rates than most segments of the market, the asset class can still suffer if rates rise quickly. Given that yields remain near historic lows across the bond market and appear likely to rise in the years ahead, short-term high yield funds offer a way to earn a decent yield while potentially mitigating the impact of interest rate risk. In addition, their attractive yields can help investors stay ahead of inflation. Keep in mind, however, that these funds are likely to underperform if economic growth slows unexpectedly.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.

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