Junk-bond chasers eye yields, downplay risks

Or, if interest rates start to increase, which will happen eventually, some investors may abandon junk bonds in favor of higher-rated corporate bonds and Treasury securities. Either event could trigger a quick, dramatic sell-off in the high-yield market.

This potential risk is one reason the Vanguard Group closed its High-Yield Corporate Bond Fund to new investors last month and capped purchases by existing investors at $100,000 per calendar year. The Vanguard fund took in some $1.4 billion in the first five months of this year, roughly double the amount that was invested during the previous five months.

Usually, funds close because money is coming in too fast for portfolio managers to make careful investments. While that is a concern with this fund, Vanguard officials also may be trying to remind investors of the risks of these funds.

"We didn't do it to be paternalistic," Vanguard spokesman Brian Mattes said. "But we wouldn't disagree with the characterization, either."

The company also was concerned that, when the high-yield market does decline, many of the investors who have entered the fund in the past few months would leave just as quickly. This could force the portfolio managers to sell bonds they otherwise would have kept. "That wouldn't be fair to existing shareholders," Mr. Mattes said.

While some financial advisers have put small amounts of their clients' money in high-yield bond funds, others are more cautious - or avoid these funds altogether.

"If interest rates flip back up, then the net asset value [share price] of these funds will come down and a lot of people will start bailing out because of the perceived loss in value," says Craig Carnick, a financial planner in Colorado Springs, Colo. "That is going to be a horrible situation. It's happened in the past, back in the 1980s when interest rates flipped."

If investors are looking for income, Mr. Carnick suggests they instead consider preferred stocks and preferred-stock mutual funds, which pay a regular dividend, often every month.

In particular, Carnick recommends closed-end funds such as the Preferred Income Fund, the Preferred Income Opportunity Fund, and the Nuveen Quality Preferred Income Fund.

Closed-end funds are traded on the New York Stock Exchange and must be purchased through a broker. These three funds, however, have been yielding about 6.5 percent a year in dividend income.

The potential for dividend income, Carnick says, is another reason he prefers preferred stock and preferred stock funds over high-yield bond funds.

Under the new federal tax law, income - such as bond-fund income - is taxed at the taxpayer's top rate, which can be as high as 35 percent, unless the fund is held in a tax-deferred account such as an IRA. The top tax rate on dividend income, on the other hand, is only 15 percent.

"You can buy dividend-paying stock in very highly rated companies, get a 6 percent return, and get substantial tax advantages, with less risk,'' Carnick says.

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