High-Yield Bond Fund
What it is:
How it works (Example):
Prices of high-yield bonds tend to be more sensitive to changes in their issuers' financial outlooks than to changes in interest rates (they actually can act as a hedge against interest rate risk), but in general, when interest rates are lower, the difference in returns among bonds of various credit ratings is larger. In other words, there is a bigger difference between what a Treasury bond might offer and what a high-yield bond might offer when market interest rates are low. This difference (the credit spread) tends to decrease when market rates are high. Thus, as interest rates fall the more attractive high-yield bonds and bond funds are to investors.
While high-yield bond funds are composed of bonds, they don't always behave like individual bonds. First, high-yield bond funds consist of bonds with differing maturities, which produces variable profits, losses, and yields.
Second, high-yield bond funds typically make monthly payments to investors, while high-yield bonds normally make only semiannual payments. Thus, high-yield bond funds provide more frequent income and a better opportunity to leverage the power of compounding when reinvesting.
One major disadvantage of high-yield bond funds (and bond funds in general) is that lower interest rates don't always raise the price of shares. When investors buy shares of a high-yield fund, the fund manager purchases more bonds with the proceeds. In a declining interest-rate environment, this means that the manager is probably buying bonds with lower coupons than before. The inclusion of these low-rate bonds in the fund lowers overall returns and the income available to investors. This in turn lowers the fund's share price. This encourages investors to sell putting further downward pressure on the fund's share price.
Why it Matters:
Most investors agree that it is usually easier and less expensive to invest in high-yield bond funds than to choose each high-yield bond in a portfolio. More importantly, a high-yield bond fund's instant diversification means lower risk -- a single default could have dramatic consequences if the investor holds one or two high-yield bonds outright. Funds also are a way to avoid the often higher transaction costs and lower liquidity associated with trading individual high-yield bonds -- it's often easier to sell bond fund shares than to sell an individual high-yield bond.