high yield investments

If we look at mutual funds, the High Yield Investments are pools of high paying bonds. This means that they are a sub-category of the income class and, more specifically, bond funds.

But what distinguishes high yield bond funds from traditional bond funds is in how they are built. Where most bond funds will be made up safe and stable bonds, high yield funds will incorporate higher risk bonds. In most cases, this means the funds will invest in below-investment grade securities. This is important to know as an investor, very important actually (we touch on this below).

Typically, high yield funds will come with higher interest rates. This means that the bonds will come with rates slightly or greatly above the normal rates currently being charged for corporate loans or bonds and clearly much higher than the rates being paid on government issued bonds.

These high yield investments have the potential for achieving great returns in 2010 for a variety of reasons. Least of these reasons lies in the fact that many of the bonds were issued by companies who have seen their credit ratings slashed by the rating agencies (like Moody's and Standard and Poors).

What do investment ratings tells us about the underlying companies?

Well, that depends. Prior to the time that the rating agencies were slapped on the wrist for "improperly" rating collateralized debt obligations (CDO's) and were scrutinized for how they rated public corporations, many of these below investment-grade companies were AAA rated. Almost all of them were indeed investment grade. But under the more-strict rating systems, a lot of them lost their ratings. And with lower ratings come higher rates.

So a company like Ford, which was arguably the healthiest (financially) of all of the domestic automotive manufacturers lost its investment-grade status and, needing capital to get it through a tough capital patch, was forced into paying much higher rates on its bonds. Was there a risk of default? Sure there was. Was it likely? Not really; nobody would have bought the bond at even those elevated rates if such risks were very tangible.

With this in mind, high yield investments stand to benefit over the coming year from the high income generated from those high rates. But there is another area where they will benefit, which we discuss next!

A couple of things happened when the credit markets seized. The first and most obvious was that investors fled to government securities, pushing the rates on those safe bonds down to the lowest levels history has ever shown us.

The second was that capital became scarce for corporations like Ford who need financing to bridge sales and receivables. And as a result, those rates increased. Why? Some would say because of risk while others would say because of supply and demand. Regardless, you get the point -- with less supply and greater perceived risk with below-investment grade companies, rates skyrocketed, creating an unnatural spread between corporate and government bonds.

This is an historic opportunity for astute investors. Why? Because as government bond rates start to rise, corporate bond rates will likely fall (not a steep fall, but a gradual one). This about this: government rates will increase because the economy is recovering and investors will demand greater inflation-adjusted rates. At the same time, investors will see that those credit risks have diminished. That means that as corporate rates drop, the price on those corporate bonds will increase, allowing investors with high yield investments to benefit on two fronts:

Higher income from the higher rates that corporations have had to pay.

Rising market values for corporate bonds thanks to rising rates.

Again, this is historic. Investing in High Yield Investments however, is something best left to the professionals.