High Yield Bond Funds Explained

If you think of the average bond fund as the ideal family car, designed for safety and dependability, a high-yield bond fund would be more like a sports car. It has the potential to get you to your destination a lot faster, and offers a far more exciting driving experience. But it certainly wouldn’t be the first choice for someone seeking reliable day-to-day transportation!

However, if you can accept a higher level of risk, high-yield bond funds just might offer you the most bang for your bond-investment buck. Many do-it-yourself investors are able to build their own stock portfolios and may benefit from buying individual government, corporate, or municipal bonds. But even the most sophisticated investor tends to steer clear of individual high-yield bonds, which are also known as “junk bonds.” With regard to our driving metaphor, investing directly in junk bonds might well be compared to riding a motorcycle without a helmet.

To understand why these bonds are so risky, you need to consider the whole system of bond ratings and how they relate to the level of income (i.e., yield) a bond offers to attract investors. Large, well-established companies with solid balance sheets will generally have higher ratings from agencies such as Moodys or S&P. Consequently, they don’t need to offer bond investors a very high yield. But a large company that’s seen some rough times or a smaller company without an established history is going to have a lower credit rating and can’t inspire the same level of trust from investors. Such a company will have to offer you a significantly higher rate of interest to persuade you to loan it money (which is what you do when you buy a bond). And such a bond will carry a higher risk of default (the failure to pay interest and principal back to bondholders) than investment-grade bonds.

So, buying an individual junk bond just doesn’t make sense for most investors. However, combining a number of them into a portfolio spreads out the risk of default and can still offer an attractively high level of income. High-yield bond fund management teams are able to research bonds more effectively than individual investors can, and have the ability to construct a portfolio that includes bonds from a wide variety of companies and industries. They can even include some higher-quality bonds to help reduce the overall risk level and provide a more stable stream of income.

High-yield bond funds from large mutual fund companies will typically include some international holdings as well. Lower-rated bond issuers can be found all over the world, especially in developing countries where changing political climates and currency rates can add an extra layer of risk to even the most solid company. It’s not usually possible for individual bond investors to participate in overseas issues, so this is yet another advantage high-yield bond funds can offer.

In short, high-yield bond funds can justify their sales loads and management fees because they enable you to benefit from the high interest payments while offering advantages not available to individual bondholders. For example, since you own shares of a fund rather than an individual bond, you can redeem those shares and access your money without having to find a buyer for the bond.

In short, even if you normally prefer to buy and sell individual securities rather than mutual funds, a high-yield bond fund may be very worthy of your consideration.