by George Tucker

Created on: January 30, 2010

High yield bond funds are easy to understand if you can grasp the basic contradiction at their heart. Investors think of bonds and bond funds as the safe part of their portfolios. Bond pricing stays steady and bonds generate regular revenue from interest payments. A bond fund is often the most boring part of a diversified investor's portfolio. All these characteristics of bonds are the exact opposite of stocks and stock funds (wildly fluctuating prices, very little revenue generated from dividends) which tend to be much more volatile and exciting.

High yield bond funds have characteristics similar to both traditional low-yield bond funds and stocks. This article explains what high yield bond funds are and how they differ from high-quality bond funds and stock funds.

What is a High Yield Bond?

A high yield bond (called a junk bond by some analysts) is a bond that is rated lower than investment-grade. The three major credit rating agencies, Moody's, S&P and Fitch, maintain a set of grades that are assigned to debt issues. These grades range from AAA/Aaa for United States Treasury bonds all the way down to C/CCC- signifying issuers who have already defaulted on their interest payments.

Bonds with grades in the top tier (above Baa3 or BBB-) are considered investment-grade. This means that the issuer is healthy and there is an extremely low likelihood of default. (See a complete list of bond credit ratings.)

Bonds with grades in the lower two tiers are considered high yield. This distinction is extremely important because investors who purchase high yield bonds demand a risk premium. Therefore, the interest rates on high yield bonds are significantly higher than on investment grade bonds. Investors should remember the words of investment guru William Bernstein, author of The Four Pillars of Investing: "Risk and reward are inextricably intertwined." High yield bonds offer greater returns because there is a significant likelihood of default on the part of their issuers, potentially leaving investors holding nothing but an empty promise.

There is a reason that those who do not favor high yield bonds call them junk bonds.

How High Yield Bond Funds Work

High yield bond funds are essentially pools of bonds rated below investment grade. Most investors purchase high yield bond funds because the interest payments received are significantly higher than those that can be found on safer debt instruments like Treasury bonds or investment grade corporate bonds. For example, at the

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