In order to properly explain High Yield bond funds, you first have to understand some finance terms. But but don’t worry – you’re already an expert in High Yield bond funds, you just don’t know it yet!
Don’t believe me? Well, lets first look closely at the name – “High Yield Bond Fund” – and work backwards, breaking it up as we go.
So it looks like there are three parts to the problem: we’ve got a a “fund”, composed of “bonds”, which pays “high yield”.
See how this works? We’ve broken apart a rather complicated sounding financial product into three, easily understandable parts.
Pretty simple, eh?
Ok, so now you know what it is. But how does it do what it does? In other words, how does a High Yield Bond Fund actually work? Fair enough. So let’s talk about some of these concepts in more detail.
First a fund. No doubt everyone reading this article has heard of “mutual funds”, those wonderful products that let smaller investors pool assets. When we invest money in a mutual fund, we’re joining forces with hundreds, thousands, perhaps tens of thousands of other investors. Our small sums of money come together into much larger amounts, which can be used far more effectively. For example, these funds can be used to hire professional money managers, or purchase different types of securities than we would otherwise be able to afford working alone.
Mutual funds have specific targets and objectives that are clearly explained when we invest our cash. A few examples: we can choose to invest in the broad market (aka an “index” fund), banking (perhaps not a good bet now), various foreign funds (India anyone?), commodities (oil, what goes up must go down) or bonds just to name a few possible objectives.
So a bond fund is nothing more than a specific type of mutual fund, one that invests in bonds.
Now we’re almost there. The final part of our puzzle is “high yield”.
This also is a very simple concept, one that’s a little obscured by its name but you’re already an expert you just don’t know it. “Yield” means nothing more than interest rates. In other words, yield is what your investments can earn you at the bank, in a CD or even in a bond.
But “high yield”? Well, in order to understand “high yield”, I first have to introduce you to two business acquaintances of mine, Reliable Ricky and Dodgy Dan.
Both of these businesses are unfortunately having problems, and approach you – Ms SmartInvestor – for a short term loan.
Each business is asking to borrow $100 for 30 days. Well, you’ve got far more than $100, and you’d like to make some extra money, and definitely earn a higher rate of return – yield – than that offered by the bank. After all, banks are safe. So to loan money to a business, any business, you’ll need to earn a higher rate of return – yield – than what you’d receive for just keeping you money in the bank.
So you set your terms.
Reliable Ricky? Let’s say you’ll charge him 1% more than you could earn in the bank. After all, he’s “reliable”. Not a problem paying his bills. Low risk. Low interest rates. You’re pretty sure you’ll get your cash back. And after all, you’re getting 1% more than you would in the bank.
But Dodgy Dan is another story. Frequently late paying his bills, loaning money to Dan is a a risky endeavor. So Dan? You need to charge Dan 10% more than you could earn in the bank. Why take on this risk if you’re not compensated for it?
And that is exactly what “high yield” is all about. Keeping in mind that yield is synonymous with interest rates, with returns, we see that “high yield” is all relative. It means nothing more than receiving higher returns on an investment than we might otherwise earn with another investment.
In finance speak: higher yield reflects higher risk.
So let’s put it all together: a high yield bond fund is nothing more than a mutual fund that invests in bonds paying high yield.
See? As I said before, you already were an expert in High Yield Bond Funds.