High Yield Bond FundsBond Funds
High yield bond funds invest in bonds which offer high return in exchange for high risk. High yield bond funds are determined by their credit rating, with high yield instruments being rated below BBB or BAA. Credit ratings is based on a firm’s liquidity, profitability, cash flow, and existing debts. Their credit rating indicates these firms are moderately to highly likely to default.
The high risk results in high volatility in both interest payments and pricing. A single economic downturn can easily eliminate many high yield bonds. High yield bond funds diversify away a substantial amount of this problem. Instead of spending $5,000 to acquire five high yield bonds you acquire hundreds in a single portfolio. Two of the five bonds you acquire may default during a down turn. In a portfolio of five these defaults would be a problem. In a mutual fund portfolio containing hundreds of high yield bonds, this is relatively minor.
These funds are highly likely to create returns when economies are stable and growing. In these conditions high yield bond funds usually exceed inflation rates. But they will also suffer a wave of defaults when economies slow or crash. Due to their number of high yield bonds, a few injuries will not cause major problems. If a large amount of defaults occurs, you may still suffer losses.
Due to the risk of high yield bond funds, you should still refrain from replacing government or corporate investment grade bond funds with high yield bond funds. You should place a maximum of ten percent of your bond portfolio in high yield bonds, or high yield bond funds. High yield bonds can fail easily under the same conditions that equities will fail. A firm which enters bankruptcy and eliminates shareholder’s holdings will also default, resulting in lost interest and a percentage of lost principal. Funds based on these instruments inherit the same difficulties.
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