As the name implies, high-yield bonds are debt securities that offer extremely generous interest rates. The downside, of course, is that these bonds are issued by companies with less than stellar credit ratings. So to capture that higher yield, investors must also assume a higher degree of risk.

That potential headache has frightened many investors away from the high-yield sector. However, at times this asset class can provide double-digit returns that rival those in the equity markets, with significantly less volatility -- and we could be headed for one of those periods.

Don't Believe Everything You've Heard
We all know that corporate bonds are essentially "IOU" securities issued to raise capital. That being the case, principal and interest payments are only as safe as the company that stands behind it.

Fortunately, rating agencies like Moody's (NYSE: MCO) exist to help sort through the gaggle of bonds available. These companies evaluate each issuer's creditworthiness through a rigorous examination of its balance sheet, cash flow visibility and overall financial stability. The companies that score highest are deemed to be worthy of "investment grade" status ("Baa" or higher), while those with a few question marks are assigned ratings that fall on the lower rungs of the credit quality ladder.

But don't make the mistake of thinking all high-yield bonds are "junk." The reputation of this group was tainted years ago with the high-profile securities fraud conviction of Michael Milken, who was instrumental in bringing these securities to prominence as a funding vehicle for hostile corporate takeovers and leveraged buyouts (LBOs).

The high-yield bond market has evolved since then and is quite appealing today, thanks to several factors:

Growing Global Market: According to Dealogic, global high-yield debt issuance totaled more than a quarter-trillion dollars in 2007, with volume reaching a record $100 billion in the second quarter alone. Much of that came from overseas markets, which now account for roughly half of new high-yield issuance.

Quality Issuers: While it's true that some high-yield debt really is junk, many companies with below-investment-grade credit ratings are actually on sound financial footing and generate hefty cash flows. High-yield bond issuers include venerable firms like General Motors (NYSE: GM), Hilton Hotels and MGM Mirage (NYSE: MGM). These three companies are just a small sample of the numerous companies from a variety of industries issuing high-yield debt.

Not Rate Sensitive: High-yield bonds typically have low durations and aren't particularly sensitive to interest rate fluctuations. Much like stocks, high-yield bond returns are driven more by the overall state of the economy -- which influences the ability of borrowers to meet their payment obligations. As a result, these bonds can actually gain ground in a rising rate environment, while others tend to struggle. This low correlation makes the high-yield sector a powerful diversification tool.

Capital Appreciation Potential: High-yield bonds have delivered average annual returns of nearly +10% over the past five years -- not all of those gains have come from interest payments. It's not uncommon for these bonds to trade at steep discounts to their par value, paving the way for significant gains if the financial outlooks for the underlying companies show signs of improvement. For example, Standard & Poor's upgraded 193 high-yield issuers in 2005, boosting the value of more than $200 billion worth of debt.

The Sky is Not Falling
Having said all this, there is still no sugar coating the biggest risk faced by high-yield bond investors: the dreaded default. For some reason or another a company may deteriorate and won't be able to meet certain loan covenants or come up with the cash to cover its payments.

While this risk is certainly real, it is often overstated and more than compensated for by the extra yield. Over the past decade, default rates for high-yield bonds have been as high as 11% in extreme conditions, but have generally averaged less than half of that. At the moment, few companies are having trouble making payments, even as the economy shows signs of deceleration. In fact, at the end of December 2007 default rates sunk to around 0.9% -- the lowest rate in nearly 30 years.

As the economy stalls and access to corporate credit tightens, that figure will quite likely rise in the months ahead. Moody's is forecasting default rates to rise above 4.2% this year. Still, that is well below the long-term historic average of 4.7%. Also, keep in mind that bondholders have a senior claim on assets over stockholders in the event of bankruptcy. Recovery rates on defaulted bonds have been as high as 60% in recent months -- well above the long-term norm.

In short, most high-yield bondholders are raking in hefty yields with little interruption. Meanwhile, improved corporate profitability and cash flows have allowed many domestic companies to de-leverage their balance sheet in recent years, which should help alleviate default pressure in leaner operating conditions.

More Bang for the Buck
Fortunately, high-yield investors are well compensated for this higher default risk. According to the Bond Market Association, the yield spread (or "risk premium") between high-yield bonds and Treasury securities of comparable maturity has run between 300 and 400 basis points throughout most of the past two decades.

In other words, if a 10-Year Treasury Bond offered a yield of 4%, then a corresponding high-yield bond might get you a much juicier payout of 7-8%. The subprime meltdown and talk of a possible recession has led to a major repricing in the credit markets. Many investors have suddenly lost their appetite for risk and are now demanding more to take it -- which has widened the spread considerably.

In fact, investors can now rake in yields more than six hundred basis points (6.3%) above the rate on corresponding Treasuries. That is more than double the 2.7% differential from this past June and marks the highest interest rate spread since 2000.

Looking Ahead
Over the past 15 years, the overall credit quality of corporate America has been trending lower. In 1992, nearly three-fourths (72%) of all debt issuers were given investment grade ratings by Standard & Poor's -- today, that percentage stands at just 50%. Meanwhile, the number of speculative "Caa"-rated issuers has more than tripled. As a result, the median credit rating of all companies has slipped.

This pronounced shift (which in part has resulted from stock buybacks and other deliberate actions) presents both opportunities and challenges. On one hand, it has increased the supply of high-yield debt, lifted yields and widened spreads. However, it also means that a recession could see default rates spike well into the double-digits.

But even that would create opportunity. During the recession of 1990, default rates shot up to nearly 8%. But when conditions improved the following year, high-yield bonds delivered a whopping gain of +44% and went on to produce returns north of +15% in each of the next two years.

Now, we aren't suggesting that exact same scenario will play out again. But, it's clear that high-yield bonds can be highly profitable investments when yield spreads have widened and the economy begins to pick up steam. We haven't reached that recovery stage just yet, but it's never too early to begin planning.

And what better way to take advantage of this potential than with a solid ETF or closed-end fund? After all, when there is more risk than usual, as is the case with high-yield bonds, it pays to diversify. But creating a personal portfolio of dozens of bonds can be a costly and time-consuming investment. Thankfully, funds offer investors a slice of this lucrative market without the headaches of buying individual bonds.

And in the latest issue of StreetAuthority's newsletter, The ETF Authority, Editor Nathan Slaughter lists four of the best high-yield bond funds available, and profiles his two favorites extensively. Both of these yield above 9.0% and stand to have considerable capital gains as the economy regains its footing. Also included in the issue is Nathan's "Fund of the Month". This month's ETF follows the recommendations of one of Wall Street's most well-known research companies. In historical testing, the fund would have returned +25,356% over the last 40 years! To learn more about The ETF Authority and these special investment opportunities, please visit this link.