A high-yield bond fund is an entity that accumulates a portfolio of bonds from companies with a relatively high risk of default. By taking on additional risk, the fund hopes to realize higher returns. Individuals can invest in the funds, entering the bond market indirectly. This can be advantageous because their share in the fund gives them a range of bond investments that they do not have to manage; they can rely on the expertise of the fund manager. Thus, high-yield bond funds allow low-maintenance diversification in a particular part of the bond market.
When an investor buys a bond, he loans the money that he pays for the bond to the issuing entity in exchange for a fixed amount he will receive when the bond matures. Some bonds also pay periodic coupons, which are interest payments. The only guarantee the holder has that he will receive payments is the word of the issuing entity of the bond. Thus, the value of a bond depends in part on the likelihood the issuer will default on the debt and fail to pay the bonds.
If investors think a company has a high probability of failure, they are reluctant to invest in that company’s bonds because they do not receive any money in the event of default. Risky companies must tempt investors with high interest rates to convince them to purchase the bonds. These high-interest bonds are called high-yield bonds.
Bond funds are a way for investors to become involved in the bond market. A fund manager accumulates a portfolio on behalf of the fund; in the case of bond funds, it is made up of bonds. Investors may buy shares of the fund. They indirectly invest in all of the bonds the fund holds, but the manager of the fund keeps track of and adjusts the portfolio. High-yield bond funds specialize further than bond funds, including only bonds with higher than average interest rates in their portfolios.
Investing in high-yield bond funds allows an investor to diversify his portfolio; however, the diversification will be over a particular segment of the bond market. Diversification allows investors to achieve any given level of expected return with a lower risk than they would have if they invested in only one asset. This is because a loss in one asset is often balanced by a gain in another. High-yield bond funds eliminate some of the benefit of diversification by focusing on one market segment because factors that affect that sector can cause bond values to move together.