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<<< Click Here for Part 2 of the Rock Solid Retirement Portfolio Series

When I was little, my mother always used to say, "Skyler, your mouth goes faster than a Trans Am." And she was right. Being a quick thinker is great for a lot of things, but it also means I occasionally make embarrassing typos because my brain's moving faster than my fingers. More commonly, I think through something in my head, and forget to put my entire thought process down on paper.

In the comments thread for my original Rock Solid Retirement Stocks article, commenter Wayneseek was kind enough to point out that I inadvertently disparaged an entire class of assets:

Skyler, I think one has to be careful when one says BONDS BAD.
Not all bonds are bad. I happen to believe there is a place for some bonds. With interest rates low and possibly going to stay low for awhile according to Uncle Ben, I think high yield bonds with their rates at 6ish% are giving a pretty good return for us retired folk.
I definitely like my dividend stocks but I like my high yield bond funds also.
Just my 2 cents worth.

He's right. My point was that Treasuries are not a great investment right now -- not that all bonds are bad. And that's why I'm reminded of my mom's old saying about the Trans Am.

Desperate Times Call For... Not-So-Desperate Measures

I find that high yield bonds are an often overlooked class of assets. Grab anyone with an IRA, and they'll probably hold stocks and Treasury bonds or a general "bond fund" in some proportion -- but a lot of people tend to ignore poor old junk bonds.

The general thesis for high yield bonds: first off, Treasury bonds are a bad idea right now because Treasury yields are unsustainably low. Buying a 30-year bond right now puts you at the risk of losing 30% on the bond's price for a paltry yield that doesn't even match the dividend yield on JNJ or PG.

click to enlarge

Second, high yield bonds are a sort of "hybrid" asset class that combines the best of both worlds of stocks and investment-grade bonds: they have returns that are on par with those of equities, but they have far lower volatility. Doug Peebles of AllianceBernstein sums up high yield bond returns as follows:

high-yield assets have delivered annualized returns only marginally below those of equities, with almost half as much volatility, over the past three decades. Yet high-yield bonds are less risky than equities, in that bondholders get paid before shareholders in bankruptcies.

Peebles goes on to state that high-yield bonds are mostly immune to interest rate risk (the primarily problem with Treasury bonds) and that a 25/75 high-yield/stocks allocation maximizes long-term return.

While choosing individual high-yield bonds requires some care and time, there are thankfully plenty of high yield bond mutual funds out there. My broker (Fidelity) offers two that have had notably good performance -- see charts below for performance of $10,000 over 10 years, assuming reinvested dividends. These funds function like mutual funds, except for bonds -- experts pick bonds that are less likely to default. Notice that while they both experienced downturns after the financial crisis, they popped back up fairly quickly.

Shows growth of a hypothetical $10,000 investment in Fidelity High Income Fund over the selected time period.

Shows growth of a hypothetical $10,000 investment in Fidelity Capital & Income Fund over the selected time period.

The reason high yield bonds can offer beneficial diversification to a retirement portfolio is that they generate consistent returns. This is great during market downturns -- while dividends may be cut or canceled and stock returns are unpredictable, your high-yield bond fund will always distribute a 6-8% annual return.

Allocation

Since high yield bonds are inherently riskier than "safe" vehicles like cash/CDs, they should always be grouped with equities in terms of asset allocation. If you currently have a 50% stock allocation, for example, you would want your total "stocks + high yield" to remain fairly close to 50%. The price of high yield bonds can decline along with stocks, so if you need quick access to liquidity, you don't want to have to sell them in a down market.

Here are my recommendations for how to incorporate high yield bonds into your portfolio.

Not Yet Retired

If you still have a while until retirement, I would recommend allocating about 10-15% of your portfolio to a quality high yield bond fund (with dividends reinvested, of course). As evidenced by the graphs above, the consistent returns of high yield bonds can help your portfolio grow no matter what the market does.

In Retirement

What you do at this point really depends on what your portfolio size and overall strategy is. If you're planning to subsist primarily on investment income (that is, dividends/bond coupons), then you may actually want to scale up your high yield bond holdings to 20 or even 25% of your portfolio. Why? Well, again, with a well-managed fund, you should see very consistent 6-8% coupon yields no matter what the market does. So for example, if you have a $400,000 portfolio, and you allocate 20% ($80,000) to high yield bonds, you should see a minimum of $4,800 in coupon yield from these bonds each year -- no matter what the market does to the rest of your portfolio, you can count on nearly $5,000 in income without. The high yield can be a nice way to balance out lower yields from investment-grade bonds or dividend stocks. If you plan to follow such a strategy, do consider diversifying with multiple funds, preferably ones that invest primarily in different bonds.

If you have a smaller portfolio and you're planning to subsist on capital withdrawals from your portfolio, you can still incorporate high-yield bonds. As described above in the "not yet retired" recommendations, consider allocating a portion of your "risk" assets (like stocks) to high yield bonds. This again ensures that you will have some good return even in down or sideways markets. On the bright side, if your more liquid, low-risk assets are starting to run short, you can always turn off dividend reinvestment and use the 6% yield to replenish your cash supply without having to sell assets in a down market.

Conclusion

The advice I've given is intended to be a generic overview to introduce the concept -- you should always examine your own financial situation and do your own research and calculations before making any major financial decisions. If you have a financial advisor, I'd definitely recommend calling them and discussing how to incorporate high yield bonds into your portfolio's asset allocation.

Here are some articles for further reading. Keep in mind that time-sensitive data (like yields) may have changed since the writing of these articles.

The New Case for Corporate Bonds - Smartmoney, June 2012

High-Yield Bonds: Equity-Like Returns With Lower Risk - AllianceBernstein, February 2012

Do High Yield Bonds Have A Place In Retirement Portfolios? - CNNMoney, September 2009

Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long FAGIX and SPHIX.