High-Yield (Junk) Bond Funds

If you are looking to expand your bond fund horizons, high yield may be the first area you've considered. High-yield bonds are often called lower-quality bonds, or junk bonds. No matter the name, these bonds offer much more income than Treasuries or other high-quality corporate bonds. That's because they have more credit risk: that is, the risk that their issuers will not be able to make regular income payments or pony up the principal they originally promised to return. In other words, if the economy slows down, or if the companies fall into trouble, they may not be able to pay back the IOU.

How junk bonds help with interest rate risk

Because credit risk, not interest-rate risk, is their Achilles' heel, junk bonds help diversify the interest-rate risk inherent with most high-quality bonds. Remember, funds favoring high-grade bonds with far-off maturities can be pretty volatile, depending on what interest rates do. But because junk bonds pay higher yields and are often denominated in shorter maturities, they aren't as sensitive to interest-rate shifts as higher-quality, longer-duration bonds are. For example, the Federal Reserve continued to increase interest rates in the first half of 2006, hurting longer-term, high-quality bond funds. But the average junk-bond fund, which is far less vulnerable to interest-rate movements, gained more than 10% for the year, affected more by declining defaults and improving corporate profits.

Some buying tips

When shopping for a junk-bond fund, examine a fund's credit quality. Is the fund investing in the upper tiers of junk (say, bonds with credit qualities of BB and B), or is it dipping lower for added yield? Check, too, to see if the fund owns any stock, convertible bonds (bonds that convert to stocks), or bonds from emerging markets. These elements would likely make the fund more volatile. Finally, examine how the fund performed during tough markets for junk-bond funds. That will give you a sense of how risky the fund could be in the future. Those tough markets will be periods when the economy faltered. Junk-bond investors experienced trying periods during the summer of 2002 (when Worldcom's bankruptcy roiled the high-yield market), and in 2008, when high-yield bond funds lost more than 26%!

Keep in mind that high-yield bond funds can be a good supplement to a portfolio already well rounded with Treasuries, corporate bonds, and mortgages, all of which offer high credit quality. But it's a good idea to consider keeping junk to less than one fourth of your bond assets.