In today's crazy interest rate world, investors are searching high and low for more interest income. One place to find it is in high-income bond mutual funds called HIGH YIELD bond funds. Let's look at June of 2009. If you required a real high degree of safety, you could get a bit over 2% a year if you tied your money up for 5 years in a bank CD. If you were willing to accept a moderate level of risk, many bond funds were yielding (paying) 5% or 6%. High yield bond funds were also available from large mutual fund companies that offered yields of 10% and more.
How can a bond fund pay interest rate yields of 10% when interest rates are near historical lows? These high yield bond funds invest in lower-quality bonds, sometimes referred to as "junk". Hence, the term often used to describe these mutual funds is JUNK BOND FUNDS. At the one extreme you have high quality "investment grade" bonds and bond funds. These are issued by entities with very high credit ratings, and the risk of default to investors is low.
At the other extreme you have junk bonds, where the issuer has a poor credit rating and default is a real possibility. If a corporation gets into financial difficulty, for example, it might default and quit paying interest to its bond holders. If things go from bad to real bad for the company, investors may fear that they will default and not be able to pay bond owners back as agreed when the bonds mature.
Either way, risk of default is real, and sends the price or value of a junk bond down. The lower the price of a junk bond, the higher the yield. For example, you buy a bond with a 5% coupon interest rate for $1000. A few years later the bond heads toward junk status and its price declines to $500 in the bond market.
An investor who buys this bond for $500 is betting that the issuer will continue to pay $50 per year in interest. That produces a current yield of 10% to the investor who bought the bond for $500 ($50 divided by $500).
The average investor is not capable of analyzing individual bond issues to find a promising high yield opportunity. Professional money managers who manage bond funds are (hopefully). If you decide to opt for high yield bonds go with a high yield bond fund. Here you will be invested in a diversified portfolio of these bonds, which lowers your risk of default considerably. If a couple bonds out of a portfolio of hundreds go bad, no big deal.
Just remember, there is no free lunch in the investment world. High yield bonds and bond funds involve risk. Their price or value fluctuates, sometimes as much as stock prices do. Their advantage is obvious ... high income.
Here are two tips for those of you tempted by these high income investments. First, consider no-load high yield bond funds with low expense ratios. There is no sense in paying a sales charge, or high expenses. This works only to lower your return.
Second, invest in increments rather than in one lump sum. For example, let's say you want to invest $50,000 into a high yield fund. Start with $10,000 in the high yield bond fund and $40,000 in a money market fund with the same fund company. Then have them set you up so that $1000 to $2000 flows each month from the money fund to your bond fund until all of your money is in the junk bond fund.
Using the above strategy, you lower the risk of investing too much at the wrong time. Plus, your money buys more shares when the fund price is lower. This is called DOLLAR COST AVERAGING, and is an effective investor tool.