Beginner’s Guide to High-Yield Bond Mutual Funds

High yield bonds are, by definition, corporate bonds that have been rated below investment grade by the various ratings agencies, which means that they have a rating of Ba or BB or lower. The top four ratings are considered investment grade, so anything in the fifth category or below is considered “junk.”

See our Beginner’s Guide to Corporate Bond Mutual Funds.

Junk bonds are issued by corporations that lack the firm financial footing of an investment-grade issuer, which means that these firms must pay a higher rate of interest on their bonds to attract investors. Those who purchase these bonds must in turn take on a greater risk of default in order to receive the higher yield. Junk bonds first appeared in the 1970s and now comprise about 15% of the total corporate bond market, or 6.5% of the entire bond market as a whole, including all governmental and municipal issues.

There are several subcategories of junk bonds; some are issued as junk while others are “fallen angels” that were originally rated as investment grade but were subsequently downgraded. Junk issues have also mushroomed in foreign markets since the 1990s and can now be found in many other countries. Junk issues resemble their investment-grade cousins in terms of technical characteristics; some junk bonds pay a floating rate of interest while others pay their interest in the form of additional bonds. Most junk bonds have maturities of 7 to 10 years, with some exceptions.

There are also zero-coupon bonds and put or call options attached to select issues. The interest and dividends from high-yield bonds is taxed in the same manner as any other type of taxable interest or dividend that is paid from corporate bonds. There may be OID issues in some cases, and capital gains and losses may be realized for those who trade these securities in the secondary market.

High-yield bonds can offer many benefits to investors who are willing to accept the increased risk of default that they carry. In addition to a higher interest rate, they may also have the potential to increase in price in the secondary market if their ratings are upgraded or the company’s financial situation improves. They are also less sensitive to changes in the interest rate environment and have historically shown a low correlation to other sectors of the bond market. They have in fact posted returns over time that are closer to those found in the equity markets than their fixed-income counterparts with a lower degree of volatility, which also makes them attractive to investors seeking a calmer avenue for long-term growth.

Many institutions invest a portion of their assets in high yield offerings for these reasons, including insurance companies, pension funds, mutual funds and other collateralized debt obligations (CDOs). Individual investors can use them to increase the yields in their portfolios while adding an additional measure of diversification.

Both open and exchange-traded mutual funds that invest in high-yield bonds can provide most of the advantages that investors seek from individual holdings in this sector with far less risk because of their diversification. Of course, most funds that invest in junk bonds in any capacity generally stick to issues that are just one or two grades below investment grade, as the risk of default becomes too high at the C and D levels.

But having just one or two companies default in these funds will usually have a relatively small effect on the fund share price, while investors will still receive the superior yield and potential for capital appreciation that they can get from buying bonds in specific companies.

Economies of scale also allow investors to acquire a portfolio of bonds at a considerably lower cost than they could if they were purchased individually. These funds also offer the standard advantages of professional portfolio selection and management as well as liquidity and tax reporting. Some funds focus exclusively on this segment of the market while other, broader income-based funds incorporate this as a segment of their portfolios. The majority of individual investors who wish to profit from this sector will therefore best accomplish this through mutual funds in most cases.

There are several types of high yield bond funds available to investors today. Some invest exclusively in domestic offerings while others focus on specific sectors or overseas. A few of the well-known options in this category include:

USAA High Income Fund (USHYX) – This fund has a primary objective of high current income with a secondary objective of capital appreciation. It has a 5-star Morningstar rating and is listed as a strong buy by Zack’s. This fund invests in junk bonds, convertible securities, senior secured loans and preferred stocks.

PIA High Yield Fund (PHYSX) – This fund invests in a similar portfolio as the previous fund listed, but will also look overseas and into emerging markets for possible portfolio holdings. It currently holds a 4-star rating by Morningstar.

T. Rowe Price High Yield Fund (PRHYX) – Unlike the previous two funds listed, this fund focuses almost exclusively on junk bonds. It also has a 4-star rating by Morningstar and has posted strong returns since 2008.

Templeton Global Total Return Fund Class A (TGTRX) – This fund seeks to provide a high level of income by investing in junk bonds around the world as well as other types of foreign corporate debt. Although Morningstar also gives it 4 stars, its expense ratio is a bit higher than the average fund in this category.

See also The Cheapest Mutual Funds for Every Investment Objective.

High-yield bonds can provide a viable alternative to both equities and more conservative fixed-income instruments for investors seeking higher yields with moderate risk. Although individual issues in this sector can carry a substantial risk of default, high yield bond funds can mitigate this risk through diversification and professional management.

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