High Yield = High Risk

• High yield means low quality and high risk. In any interest rate environment some bonds pay more interest than others to compensate for the higher risk that investors are taking with their money. High-yield bond funds can invest in low quality corporate, municipal or foreign bonds.
  
  

Bond Ratings

• Bonds are rated by credit rating agencies based on the issuer's ability to pay interest and repay principal at maturity. The rating methodologies vary but generally the highest ratings go to the investment grade bonds; low quality bonds are called below investment grade, high yield or junk.
  
  

Bond Dynamics

• Once a bond is issued, it trades in the secondary market and its credit rating may change with changing economic and financial conditions. A high-quality bond may become a high-yield bond after a series of rating downgrades and vice versa.
  
  

Types of Bond Funds

• Open-end, closed-end and exchange-traded funds (ETF) can all invest in high-yield bonds. Open-end and closed-end funds have an investment manager and a stated investment objective; ETFs are unmanaged and are typically based on a bond index. Open-end funds issue and redeem shares based on the inflows and outflows of investor funds. Closed-end funds issue a fixed number of shares that investors can buy and sell on an exchange like a stock. ETFs also trade like stocks but the number of shares vary based on investor fund inflow and outflow.
  
  

How Safe Are High Yield Bond Funds?

• According to Moody's, historic high yield default rates range from 4.5 to 20 percent. But most bond funds are broadly diversified so that an occasional default will not do much damage to the portfolio.
  
  The bigger risk is investor perception and market behavior. Like other types of securities, bonds are susceptible to periodic selloffs. If investors as a group perceive that high-yield bonds have become risky, they will flee high-yield bond funds for the safety of government or investment grade bonds and their selling will depress the prices of high-yield bonds. Eventually prices may recover but not before many panicked investors have sold their high yield holdings at a loss.