High yield bonds represent an appealing yet complex allocation for investor portfolios. In fact, this asset class arguably carries more varied risks, and potential opportunity, than any other publicly-traded fixed income or equity category.

High yield bonds are generally defined as having a credit rating below the lowest investment grade (BBB or Baa). They have shown a much stronger correlation to stocks, while their safer counterpart, investment grade bonds, are very interest rate sensitive and behave more in line with Treasury and mortgage-backed securities.

But complex risk and reward attributes also make high yield bonds an asset class that cannot be adequately described with generalizations.

The estimated $1 trillion size of the U.S. high yield market is impressive. However, it represents a small fraction of the $33 trillion-plus U.S. bond market, as of Dec. 31, 2008. While new issuance has weakened in 2009 and was also down considerably last year, this follows five years of healthy growth through 2007.

Mutual funds are an ideal high yield vehicle for many investors given the importance of diversification, trading expertise and liquidity management in this market.

Many of the bond issues come to market as 144A, or unregistered, offerings and are out of reach for individual investors outside of a mutual fund structure.

Of course, gaining access to the expertise required to successfully manage a high yield bond portfolio is an investor's main motivation for selecting an actively managed fund. Fund selection should be guided by a solid understanding of several key performance drivers and their ramifications.

Individual issues are differentiated by their specific risk characteristics, including those defined by the terms of the bond indenture (the legal contract), and others driven by the market pricing or operational performance of an issuer. Indentures spell out the mechanics and options around required interest payments, the conditions that define a bond default, and the collateral-if any-standing behind a bond. Clearly, these characteristics make up a piece of the risk puzzle that every fund manager must solve.

An aggressively positioned fund may emphasize bonds having pay-in-kind (PIK) or toggle provisions that allow a company to issue more bonds in lieu of cash interest payments.

Bonds with less restrictive language, commonly referred to as "covenant-lite," have greater freedom to leverage their balance sheets and stretch their cash flows. This includes many of the more recently issued bonds used to finance leveraged acquisitions. Less restrictive language also may have the effect of drawing out the current cycle of defaults as companies move from technical violations of the covenant's terms, to cash defaults involving missed principal or interest payments. And companies operating longer in an impaired state often draw down resources otherwise available to bond holders in a default, affecting overall recovery rates.

Market pricing and an issuer's business performance will impact risk in several ways. Bonds selling at steep discounts to par, perhaps due to operating difficulties or rating downgrades, may be judged an acceptable risk given their greater upside potential relative to more secure bonds or new issues selling closer to par. Portfolio credit ratings should be viewed as a basis for further inquiry, rather than as a definitive screening tool. Published manager commentary can be invaluable in this regard, as it is easy to misunderstand the risk and opportunity behind any statistic.

Sector positioning is another method of adding or reducing risk. Currently, fund managers betting on a sustainable economic turnaround may favor cyclical industry exposures. More conservative funds may maintain a bias toward sectors having less fixed assets and related capex charges, given the unsecured status of most high yield bonds. Cash flow and balance sheet flexibility trump tangible collateral when your claim is at the bottom of the ladder. (High yield does, of course, stand on the rung above common and preferred equity).

Every high yield manager is focused on the current potential for defaults and estimates of recovery given default. Opinions vary as to where we are in the cycle and whether valuations imply a reasonable estimate of what is to come. Similar to equities, high yield bonds have tended to rally prior to peak rates of distress. But history may prove a less reliable guide for navigating the tremendous economic dislocation seen today.

The complexities of high yield investing are many, and each may represent an opportunity for an astute fund manager. The selection of an appropriate fund requires more study than calculation, which is always a good starting point for adding value.

TIM KNEPP, CFA, serves as chief investment officer of Genworth Financial Asset Management (an Encino, Calif.-based unit of Genworth Financial), as well as chairman of the firm's investment management executive committee. He can be reached at tim.knepp@genworth.com.