Not very long ago, the idea of the income asset class, and bond funds in particular was to provide a decent level of interest income. A nice byproduct of bond funds was some of growth potential they had when bought at discounts or sold at premiums. Such mutual funds were rather blase, boring, even cookie cutter. But insofar as investment management was concerned, bond funds made a lot of sense. They paid better than cash-equivalent funds and for those rates they were still considered liquid; you were never locked in with these bonds funds like you might have been with a term deposit.

But bond funds of yesterday were a little misleading. They filled a void, sure. But they were boring underperformers that betrayed the true potential for wealth that bonds can offer. And for many income class investors, that potential for wealth was and still is tremendous.

One of the reasons why bond funds offer such great potential is thanks to nothing other than this most recent recession the entire world has had the (dis)pleasure of enduring. Perhaps the biggest benefit has come in the form of higher borrowing costs for corporate entities, all while government rates dropped to unprecedented lows. This, in turn created wider-than-normal spreads, presenting an historic opportunity for investors who are new to the income class.

Where investors stand to benefit however is in the arena of high yield investments, themselves bonds. What distinguishes these high yield investments from traditional investment-grade bonds is the coupon rate, or the rate of interest that the companies must pay to the bond holders. In the case of high yield investments, the rates paid are considerably higher than investment-grade or even government bonds because a lot of the companies whose bonds are held within the portfolio have been downgraded by rating companies like Moody’s and Standard and Poor’s.

In fact, many of the companies whose bonds make up the portfolios of these bond funds were rated as investment-grade just a couple of years ago but ever since the rating companies came under fire for some of the ratings they gave to some of those fancy Collateralized Debt Obligations (CDO’s, remember those?). Ultimately, the high yield bond funds are below investment-grade with BBB, BB, B ratings and some rated below B.

But, of course, the companies that issue these bonds need to pledge collateral against these bonds. This collateral is often an important asset to the company, vital to its ability to generate income. Now, consider a company that has bonds against which is pledged a considerably important asset to that company’s success. In addition to this debt, the company has probably issued common stock, or equity. In some cases, there may even be a dividend to be paid on such common stock, but it is rather unlikely (though not impossible) for below investment grade common stock.

A quick review of this scenario reveals that the first people to get paid first are the bond holders. So if there ever were any financial troubles, the bond holders would be paid first. The company, not wanting to risk losing this asset, vital to its ability to generate a single dollar, will do everything in its financial power to ensure their bond holders, where such bonds are investment grade or not, are satisfied. That the terms of their agreement are met.

And with spreads as wide as they are, all companies are paying a considerably higher coupon on their bonds. Therein lies the true opportunity for bond funds…. until those spreads start to narrow. And they will narrow, there is no question. As the economy recovers, all spreads will narrow. Government bond rates will rise and corporate bond rates will drop. Existing corporate bond prices will increase while government issues will drop.

So, in a nutshell high yield bond funds offer a great opportunity right about now. Most bond funds hold securities where the coupon is high. As rates drop, so will the bond price (that inverse relationship is a pretty thing). This helps with capital appreciation. But since the coupon was high to start with, there is also a nice trickle of income being poured into the investment. In essence, today’s high yield bond funds are not the same as the bond funds of yesterday. In fact, they are better. How much better comes down to an average yield of 10+% and 2009 performance of better than 35%.

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