Junk for Joy

05/21/2012 6:45 am EST

Focus: BONDS

Margaret Patel

Managing Director and Senior Portfolio Manager, Wells Fargo Advantage Funds

High-yield bonds have room to run in a fixed-income environment that has whittled rates to the bone, says Margaret D. Patel, managing director at Wells Fargo Advantage Funds.

Margie, in a low interest rate environment, how should retail investors be allocating fixed income in their portfolios?

Well, at this point I think investors should be relatively selective, and frankly think about underweighting the kind of overweight that many people have had for many years because rates are low. They’re going to stay low for risk-free securities, and I think there are better alternatives in areas that have more volatility, maybe a little bit more risk.

For example, what might some of those areas be?

Well I think high yield—so-called junk bonds—are the most attractive part of the fixed-income market, because there you still get a relatively high yield. A yield of, say, 4.5% to 8%. So on average, call it close to 7%.

And because those yields are so much greater than Treasuries—ten-year Treasuries are only about 2%—I think those bonds can have a little bit of capital appreciation, so in addition to the income you could make some modest capital appreciation. Maybe have returns close to double digits. So that looks pretty good in an uncertain world.

How do you feel about muni bonds, for example, versus corporate bonds?

Well, muni bonds are very attractive for the conservative investor. If you look at the pre-tax equivalent compared to high-yield bonds, I think the pendulum slightly favors high-yield bonds for the extra yield and the extra return.

On munis today, they yield more than Treasuries because Treasuries are so abnormally low. And I would say for a muny investor who wants to maintain quality and is desperate for yield, the best choice is to extend maturity a little bit. Investors often don’t like to go beyond ten years, because they’re worried about rates, but if they went from ten to 15 years they could pick up maybe a whole percentage point in income in a market that’s been pretty safe.

So that’s what I would think. I think munis are attractive too.

Anything in particular that you see as potentially risky that investors should avoid?

I don’t think there’s much risk in the fixed-income market. I think it’s very premature to think we’ll have a big uplift in inflation. Investors would love that, because then rates would go up, and they could get high income. I don’t think that’s going to happen.

I think the bottom tier part of the high-yield market, the most speculative bonds that have yields of 10% or 12%, are more highly risky. It’s a very crowded field, people looking for that yield, and I think that’s the one place I would avoid because of the risks. Also, if there’s risk in the fixed-income market, that sector has a lot of risk, and not that much upside for the risk of what you could lose.

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