Try Some Junk Bonds — But Not Too Many

In these yield-challenged times, there’s no sin in scavenging for an extra point or two in returns. But higher yields mean higher risk—particularly in high-yield or “junk” bond funds, which invest in corporate debt that has been deemed below investment grade by ratings firms. It is easy to see why investors are tempted by the funds. Junk bonds are yielding an average of more than 5%, compared with just above 3% for investment-grade corporate bonds and more than 2% for a 10-year U.S. Treasury note. As long as you recognize that junk bonds have a higher risk of not paying off in lean economic times and may be currently overpriced relative to other corporate bonds, they make sense in a well-rounded income portfolio. Yet there’s no need to load up on them. Experts generally advise putting no more than 5% of a fixed-income portfolio into junk bonds.

Holding both investment-grade and junk-bond funds is a better idea and makes it less likely you’ll be thrown off a cliff if junk bonds lose favor for an extended period. Keep in mind, though, that bond funds can lose value if rates rise—the longer the maturity, the greater the downside hit. The SPDR Barclays High Yield Bond exchange-traded fund, which holds a $9.3 billion portfolio of lower-quality corporate bonds, is up 4.8% this year through Sept. 4, beating the total U.S. investment-grade bond market—as measured by the total return of the Barclays US Aggregate Bond Index—by nearly one-half a percentage point, according to investment-research firm Morningstar. The fund yields 5% and charges 0.40% in annual expenses, or $40 per $10,000 invested.

Try to avoid timing the market, which can make you vulnerable to market turns. That means not being sucked into overinvesting in long-term U.S. Treasury bonds, which are more sensitive to interest-rate changes than junk bonds, but have seen prices rise this year due to a slight dip in rates and a global flight to high-quality government bonds. The iShares 20+ Year Treasury Bond ETF, a fund that holds the longest-maturity Treasury bonds, is up 16.4% this year through Sept. 4. The $4.3 billion fund charges 0.15% in annual management expenses and yields 3%.

Still, funds that hold long-term Treasurys are surprisingly more vulnerable to sharp price swings than those that hold junk bonds. The iShares fund, for example, is more than four times more volatile than the Barclays index, according to Morningstar. “Treasurys are most susceptible to price hits when rates rise,” says Jeff Layman, chief investment officer at BKD Advisors in Springfield, Mo. “It’s unwise to buy Treasurys, even though the 10-year note has fallen in yield from about 3% to 2.4% this year. I don’t think this move is likely to repeat itself.” Mr. Layman says he is steering clients to high-yield municipal bonds, which he feels present less risk than corporate junk bonds and long-term Treasurys.

An all-purpose bond ETF can serve as a simple way to get broad diversification. The $21 billion Vanguard Total Bond Market ETF, which invests in intermediate-maturity corporate, mortgage and Treasury bonds, samples most of the U.S. bond market except for Treasury inflation-protected securities and junk bonds. The ETF is yielding 2% and is up 4.4% this year through Sept. 4. The fund charges 0.08% in annual expenses.