High-yield bond funds are attracting huge amounts of investor money these days. Given today's interest rate environment, this is a trend that is completely understandable -- and dangerous. With savings account interest rates near zero, and U.S. Treasury yields under 2 percent, it is only natural that investors are looking elsewhere for income. High-yield bond funds are being marketed as the answer, but before you buy a high-yield fund you should know that they represent a level of risk much higher than savings accounts or Treasury bonds. Here are four things you need to know before you invest in a high-yield fund.
1. High-yield is another way of saying "junk"
Never forget the old rule that you can't get something for nothing. When it comes to the income that different investments yield, that rule means that higher yields come with higher risk. The reason high-yield bonds are paying so much more interest than savings accounts or Treasury bonds is because there is a risk that the issuers of those bonds might not be able to pay the full amount of interest and principal due over the life of the bond. Because of their low credit quality, these high-yield bonds are also known as junk bonds -- but you can understand why fund marketers prefer to label them as high-yield bond funds rather than junk bond funds.
2. Price variations can overwhelm yields
Investing in bonds when interest rates are low can be a risky business. Bond prices move in the opposite direction from interest rates, so if rates go back up, bond prices will go down. Bond prices can also fluctuate if the perceived credit risk of the issuer changes. The point here is two-fold: First, the lower interest rates go, the more likely they are to rise than fall in the future. Second, low interest rates provide very little cushion against price fluctuations. The bottom line is that you can't just focus on the yield of a bond fund, because your total return might be determined primarily by price changes rather than interest.
3. Mutual funds won't necessarily realize the underlying yield
There is an important difference between investing directly in bonds, and investing in bond mutual funds. When you own a bond directly, you know that as long as the issuer doesn't default, you'll get the yield you bought into if you hold the bond to maturity, regardless of price fluctuations in the interim. A mutual fund, on the other hand, may be buying and selling bonds without holding them to maturity, and poor investment decisions can fritter away your return. Fees also take a cut, meaning that when it comes to the yield on a bond fund, what you see isn't necessarily what you'll get.
4. Recent bond returns are misleading
The record drop in interest rates over the past few years has boosted the return of bonds. However, the magnitude of that drop in rates is not likely to be repeated in the years ahead, so neither are those bond returns. You can earn some extra yield safely simply by shopping for better money market account and savings account rates, especially if you consider online banks. However, once you take the bigger step of reaching for income in a high-yield fund, you have crossed the line between safety and speculation.