High-yield and emerging-market bonds have delivered stellar returns over the past decade. Should advisors use these investments to spice up clients’ fixed-income allocations?

Through January, Morningstar’s intermediate-term bond category posted annualized 10-year returns of 3.7%. Meanwhile, the high-yield and the emerging markets bond fund categories nearly doubled that number, at 6.7% and 6.3%, respectively. In the market turmoil of early February, high-yield and emerging markets bond funds showed their volatility by falling more than intermediate-term bond funds, but the numbers indicating 10-year superiority remained virtually unchanged

Given that record through a bust and boom, it’s not surprising that these funds are attracting considerable attention.

Many advisors favor either or both. “Emerging-markets bond funds and high-yield bond funds provide diversification to the traditional stock and bond components of our clients’ portfolios,” says Kelly Henning, a financial advisor at Modera Wealth Management in Westwood, New Jersey.

“One of the current concerns surrounding U.S. investment-grade bonds is increasing interest rates,” Henning says. “Emerging markets bonds are not directly exposed to the U.S. interest rate environment, so they are a welcome addition to our clients’ bond allocations.”

Not everyone is jumping on the bandwagon, though. “In fixed income, my emphasis is on capital preservation,” says Timothy Hayes, founder and president of Landmark Financial Advisory Services in Pittsford, New York. “Therefore, I don't like the sovereign and/or credit risk that comes with emerging-markets bonds and high-yield bonds. Typically, I don't typically follow them, recommend them to clients, or buy them myself.”

Weighing the tradeoffs: Henning cites several other positives to emerging markets bonds, as well. Developing nations tend to have lower debt-to-GDP ratios and stronger growth potential than developed countries, she says. And while yes, emerging markets bonds can come along with higher risk than their investment grade counterparts, she notes they also tend to compensate clients with higher returns.

“The potential downside of high-yield bonds was readily apparent during the credit crisis, when those funds declined over 20%,” Henning says. In 2008, amid that crisis, large blend stock funds fell 38%, emerging-markets bond funds lost 18%, and high yield bond funds lost 27%, in sharp contrast with intermediate-term bond funds, which declined just 5%.

But emerging-market and high-yield bond funds also come with higher payoff potential. In the 2009 rebound, for example, these funds roared back with a vengeance. Emerging-market funds gained 32% and high-yield funds were up 46%, whereas intermediate-term bond funds and large-blend stock funds posted smaller gains of 13% and 28%, respectively.

Portfolios at Henning’s firm often have a total 10% to 30% allocation to these categories. For example, a client with a 60-40 allocation, stocks to bonds, might have as much as 12% of the overall portfolio in high-yield bonds and emerging-markets debt combined. “This allocation helped to bolster investment grade bond returns over the past two years,” Henning says, “but adding funds beyond 30% could meaningfully detract from the performance and raise the risk level of the portfolio.”

Indeed, Henning adds a few words of caution. “These two asset classes have had two years of strong performance accompanied by bond spread compression,” she says, referring to how strong demand for lower quality bonds has led to lower yields. “As a result, there’s a need to keep an eye on the risk/return attributes of these funds and be careful about further investments.”

The recent strength of both bond categories has prompted Modera Wealth to review those holdings. “To maintain our targeted risk level,” Henning says, “we decided to reduce our exposure to the lower end of the 10% to 30% range. Spread compression has produced lower expected returns.”

Split decisions: Some advisors use emerging-markets funds but not high-yield funds. “We believe that emerging markets bond funds provide good diversification within a bond portfolio,” says Diahann Lassus, president and co-founder of Lassus Wherley, a wealth management firm in New Providence, New Jersey, and Bonita Springs, Florida. “Yields continue to be reasonable — about 5% from the fund we mainly use — and the returns have been good for the risk investors take.”

Emerging-markets funds may hold local-currency bonds, dollar-based debt or both. “The fund we tend to use is U.S. currency based, so we have some concerns around the weak dollar,” Lassus says. “However, we are long-term investors and are not as focused on short-term movement. There is definitely a need to diversify bond portfolios outside of U.S. fixed income and the emerging markets area can add value, at a slightly higher risk.”

That said, Lassus is more cautious on high-yield funds. “We don’t use high-yield funds specifically,” she says. “We do use funds that may allocate their holdings across several different bond sectors, including some percentage in high yield.”

Spreading the risk: “I am a big believer in diversification,” says Sheryl Rowling, head of rebalancing solutions for Morningstar and principal at Rowling and Associates, a financial advisory firm in San Diego. When she considers any potential portfolio addition, it must meet one of the following three criteria:

1. It increases return without increasing risk;

2. It decreases risk without decreasing return; or

3. It increases return and decreases risk.

Emerging markets bond funds pass the risk/returns test and merit a small allocation in clients' portfolios, Rowling says. But she is not a believer in high-yield bonds.

“In today's environment of low interest rates, many investors chase returns by moving to lower quality,” she says. “I would not cross the line into junk bonds because I believe the risk outweighs the potential benefit.”

Rowling’s aversion does not apply to municipal high-yield funds, however, which “are not close to junk,” and thus may merit a place in client portfolios, she says. A similar line is drawn by Glenn Frank, director of investment tax strategy at Lexington Wealth Management in Lexington, Massachusetts, who includes emerging-markets funds and muni high yields in clients’ portfolios, but excludes high-yield funds owning taxable bonds.

“I would not invest in high-yield corporate bonds today,” Frank says. “High valuations make them risky. To make matters worse, they have relatively high correlation with U.S. equities, which are risky enough by themselves, given their lofty valuations.”

Plumper payouts: Frank also cautions on traditional fixed income positions. “Core fixed income is low-yielding today, with some risk,” he says. “It may be better to use higher yielding fixed income categories that behave differently from each other, so the group as a whole isn't that risky, yet still gets better yield than core fixed income.”

Thus, Frank opts for preferred stock and bank loan funds, along with high yield munis. “They are better choices for yield, with lower correlations to stocks,” he says. “With this approach, about half of a fixed income allocation might be in unusual holdings while the other half is in core fixed income. Our core now has a healthy dose of Treasuries as a hedge, in case of a flight to quality during a possible drop in equities.”

Where do emerging-markets bond funds fit in Frank’s outlook? “Emerging-markets debt correlations with U.S. equities are not quite as high as is the case with high-yield corporate bonds,” he says. “In addition, emerging-markets debt valuations are not as high. Therefore, I would pick emerging markets over high-yield corporate bonds.” Emerging markets bond funds may have fairly high ordinary income yields, generating steep tax bills in taxable accounts, so Frank favors holding them in retirement plans.

Stocking up? One question that arises is whether emerging markets and high-yield bond funds are really necessary, given their volatility and correlation to equities. If clients are willing to take more risk, why not just increase their equity allocation? “It's generally fair to say that clients with an above average risk tolerance can increase their allocation to equities, if it’s done carefully,” Hayes says. That could be preferable to using riskier types of bonds, he adds.

Rowling, however, doesn't believe that emerging-markets bonds and high-yield bonds should be equated to equities. Lassus concurs, saying that, “We wouldn’t normally replace any type of bond with equities, given the difference in the risk characteristics. We focus on making our bond portfolio the cornerstone of the safer part of the overall portfolio, maintaining more exposure to shorter-term and lower-risk bond funds. For that reason, we invest only a small percentage in emerging markets bonds.”