How do high-yield funds behave in a rising-rate environment? Are they too risky to be held in a conservative portfolio?

QUESTION: I hold shares in the T. Rowe Price High Yield (PRHYX) and Janus High Yield (JAHYX) funds. How do high-yield funds behave in a rising rate environment like we have today? Are they too risky to be held in a conservative portfolio?

-- Anonymous

ANSWER: Timely questions. Just two years ago, high-yield bond funds boasted double-digit returns. Now, they're the biggest losers in the bond fund category, down 1.81% year-to-date, compared with 0.02% for taxable bonds as a whole, according to fund research company Morningstar (data as of April 25).

Does that have anything to do with interest rates? The simple answer: Yes. But there's a lot more to the dreary performance of high-yield funds than the Fed's rate hikes.

Herewith, a quick tutorial on high-yield bond funds and the major economic factors that drive their performance.

As you probably know, high-yield bond funds invest in junk bonds, which are rated "below investment grade" by the rating agencies (like Moody's and Standard & Poor's) and are issued by companies that are considered more likely to default on their debt obligations than the U.S. government or companies that issue investment-grade bonds. High-yield bonds and bond funds, therefore, carry risk. To compensate for that, they typically offer higher yields than Treasurys or investment-grade bond funds. And because they have higher yields, they are actually less sensitive to rising interest rates than other bond funds.

Since high-yield bonds are issued by companies, however, their performance is closely tied to the stock market and the strength of the economy, explains Andrew Clark, a senior research analyst at mutual fund tracker Lipper. "There's an old joke that high-yields are basically stocks with a coupon," he says. "They move very much like the stock market, only you're getting regular coupon payments, because it's a bond." The risk is, of course, that the company issuing the bond could default on its repayments. The higher that risk, the higher the company must pay in interest.

But as the economy gets stronger, the credit risk associated with junk bonds drops as companies are more likely to repay their debt obligations successfully, explains Scott Berry, senior fund analyst with Morningstar. Lower risk, in turn, leads to a drop in yields. And as junk bond yields get closer to Treasury yields, their sensitivity to interest rates -- something they were able to avoid because of their higher yields, remember? -- increases . This is what has been happening in the past 12 months, says Berry. "We saw that early last year when rates spiked up, and we saw it this year when rates spiked up."

Recently, the bond world has been rocked by the profit warnings issued in March by General Motors (GM) and in April by Ford (F). This has prompted some analysts to predict downgrades of the companies' bonds to below investment grade by the end of the year. Should this happen, says Berry, the whole junk-bond market would be affected as a likely rush to buy GM and Ford bonds would trigger a selloff of other junk bonds, which in turn would lead to a further fall in prices.

So what does all this mean for high-yield funds? The market certainly seems to be carrying more risk now than it normally does, Berry says. "Everybody expects rates to go up more, which could put pressure on the high-yield bond market." But defaults are still low and the economy is still stable, Berry adds, which should at least provide high-yield funds with some cushioning against rising interest rates.

In other words, it all comes down to adjusting investors' expectations. High-yield funds did tremendously well in the past couple of years: average returns were 24.47% in 2003 and 9.91% in 2004, according to fund researcher Morningstar. (In contrast, taxable bond funds as a whole returned 8.47% in 2003 and 4.87% in 2004.) But given the current situation, Berry says, investors shouldn't expect those returns in the near future. "It looks like we're going through more difficult times," he says.

Which leads to your second question: Are high-yield funds too risky for a conservative investor? That depends on many factors, including one's investment horizon and overall risk tolerance. One way of looking at it is answering the question: How much of a loss can an investor comfortably handle? Let's look back at the biggest losses that high-yields have suffered since 1980: In 1990, high-yield funds lost 9.3%; and in 2000, the average loss was 7.1%. If an investor isn't uncomfortable with that type of loss, Berry says, they might want to consider trimming down on high-yield funds. (Just make sure you preserve an overall asset allocation that's consistent with your investment goals and risk tolerance.)

For Harold Evensky, a fee-only Certified Financial Planner (CFP) with Coral Gables, Fla.-based Evensky & Katz, high-yield funds aren't for everyone simply because they're too complex. "If someone says they're conservative, they probably don't belong in them," he says.

And what about the two funds specifically mentioned? Both of these funds are market-driven, which means they follow overall market trends quite closely, according to Berry. "If the junk bond market suffers, I would expect these two funds to suffer along with it," he says.

One final note: Given the complex nature of these funds, it's worth asking whether an investor really needs two such funds in his or her portfolio. Unless there's a compelling reason for double-dipping into this corner of the bond market, it could be time for some spring cleaning.