How Does a High Yield Mutual Fund Work?

1. The term "high yield" refers to bonds that are below investment grade, also known as "junk bonds." These bonds usually come from struggling companies that may be on the brink of bankruptcy, though even good companies periodically fall on hard times, so junk bonds can often be a solid investment that pays its holder handsomely. The main risk of holding a junk bond is that the default rate is high relative to other bonds.
2. High yield mutual funds refer to professionally managed funds which invest in junk bonds. These funds draw in capital from private investors and use the money to purchase a variety of low grade bonds that its managers feel have a high chance of paying out. Before investing in a high yield fund, it is wise to inquire about the performance history of the fund, as well as the bonds which it holds.
3. Since the junk bonds are a high risk-high reward market, diversification is a must. Mutual funds buy up many different bonds, which spreads the risk of default across many investments, creating a hedge against total investment loss that one could suffer from holding only a few junk bonds that go into default. The theory is that even if a few of the funds holdings default, there will be enough that do not to make up for the ones that fail and still turn a nice profit.