4 Bond funds have different risks from bonds: If you buy a quality bond and hold it to maturity, you will get your money back. Sure, a Treasury can move up and down, but held until maturity it will pay back its investment. Not so with all bond funds. If markets go topsy-turvy and a bond fund faces redemptions, they sell what they can, sometimes at a loss. Hence, it is another risk factor that you simply do not have in bonds themselves or bond index ETFs.
5 Income/Yield: Remember the first law of economics: There is no free lunch. You must be careful in chasing higher yield. Fixed income is supposed to be your safe money — what you must get back and what will cushion the ups and downs of the equity markets. Your first concern should be return of your money, and, second, the return on your money.
In other words, bonds are supposed to be your safety first investment.
You can create a higher yielding portfolio — one that generates more income than risk-free treasuries do. This means you are assuming more risk. If you are willing to accept that, including a possible loss of principal, then there are ways to build a portfolio that generates more income.
My caveat: I treat these holidngs like stocks, not bonds, which means that when they begin to misbehave, I kick them out of the portfolio. I always prefer selling for a small loss now vs. a big loss later.
If you respect those caveats, and can exercise some discipline in managing risky positions, here are a few places where you can look for yield:
Mortgage-backed securities: These were a disaster during the 2007-09 crisis. The working assumptions of buyers today is that the worst is over, and these mortgages are trading at a discount. Hence, that moderates the risk levels somewhat. Much of the subprime junk has already defaulted, so risk is out of them. Most people who were going to default on their mortgages have already. There is some truth to this, but there remains a healthy amount of risk in the space.
Corporate bonds: The safest of the non-Treasury bonds. Quality (non-junk) corporates yield between 1 to 7 percent. Corporate bond ETFs often hold hundreds of bonds, have low-expense ratios and yield more than 4 percent. Given that U.S. corporate balance sheets are as strong as they have been in a very long time, this is an attractive risk-reward relationship.
Junk bonds: Even higher yielding and, therefore, much higher risk. Some of these funds yield more than 7 or even 9 percent. They are much more vulnerable to specific failures of any company. Junk bond funds often see defaults that eat into principal. This should never be a large portion of any portfolio.
Master Limited Partnerships: Typically involved in extracting, shipping or storing a natural resource. They pass through 90 percent of their net income. Often, MLPs yield 5 to 8 percent. The problem investors have with these is they require a K1 tax filing, which most accountants hate. The solution is that there are now at least two ETFs that bundle 20 to 30 MLPs — no K1 filing needed. A risk is that eventually these resources are exhausted.
REITs: Are a type of fund that owns commercial real estate such as apartment buildings, office buildings and shopping malls. They get a special tax treatment that requires them (like MLPs) to pass through 90 percent of their net revenue. Yield can range from 3 to 8 percent. The downside is they are economically sensitive — meaning they don’t hold up well in a recession.
Sovereign debt: Owning the bonds of sovereign nations comes with various levels of risk. If we ignore Greece and Spain and instead focus on nations such as Vietnam and Brazil, we can find higher yielding paper for modestly higher risk. Some closed end funds that do this use various levels of leverage. This magnifies the yield but also can magnify losses. If you own any of these funds that use leverage, stick with ones that use modest amounts.
Owning a yield portfolio is a way to obtain higher income but with appreciably more risk. Proceed with caution.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz. For previous columns, go to washingtonpost.com/business.