It should come as no surprise that the Mutual Fund Site has taken some fire for naming a High Yield Investment (one of the top performing Bond Funds of 2009 as it turns out) as its Top Pick for 2010. After all, Bond Funds were one of the best performers over the past year and a lot of folks believe that you cannot keep a good thing going. And while they are right (you cannot expect year-after-year returns of 40-50%), they are probably wrong about High Yield Bond Funds for the next year. We have three arguments in favor of this group of mutual funds and outline how investors can make extra sure they don’t get burned with the wrong type of investment strategy.

1. Look for highly ranked funds. Morningstar does a great job of ranking funds, but if you use their ranking system, look for funds with steady rankings or consistently improving rankings. That means if you go with a five-star fund, make sure it has been a five-star fund for the 3 year, 5 year, 10 year and overall periods. If not, why? Is it a matter of a bad year overall, management changes, etc.. A five-star fund today should have been a four or five-star fund for the past 3 periods.
2. Consider the holdings, or investment portfolio of the fund. Mutual Funds will have great long-term performance if they hold the “right” securities. The same holds for bond funds. While most bonds will have an asset attached in terms of security, thereby minimizing risks to the investor, the worst thing that can happen to a bond holder (including the mutual fund company) is that the company is forced to realize on the security because of a default on the bond. With this in mind, take a peek at the fund’s holdings. Insofar as investment management, do you agree with the fund’s choice of bonds? If you are bullish on Ford and the bond fund holds GM, a stock you are bearish on, then why pick that fund? What other types of disagreements will there be? In this illustration where you are bullish on one company and bearish on another, you could also consider the total weighting within the fund. In this example, if they hold 0.08% of GM Bonds but the remaining 24 top holdings are okay with you, then I would not necessarily sweat it.
3. Since most top performing high yield investments will hold an average of B-rated bonds, you can take a look at see how their style has changed over the past 3 years. You can also determine how quickly they turnover their assets by measuring asset turnover. One thing you may want to be weary about is whether their investment strategy (or style as noted on Morningstar). If their turnover is high and their strategy has changed from one year to the next, then there are some considerable risks involved. However, an investment strategy that has remained fairly stagnant over the past three years combined with an “average” turnover rate suggests the fund’s strategy has remained relatively the same… they are doing something right.

The three considerations above show us the importance of choosing highly ranked funds. In other words, funds that are held in high regard within the industry. They will achieve this through proper investment management, as demonstrated by their holdings and proper weightings. And since most high yield bond funds will show their average bond rating of B, measure their consistency by viewing their investment style.

It will not be too difficult to complete these three things before investing in bond funds. And since there are so many skeptics out there when it comes to this asset class, making sure you have done you homework properly will help you sleep better at night despite the blasphemous remarks (okay, that was a little strong) being written out there.

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