With interest rates at historic lows and money-market funds barely paying, high-yield and multi-sector bond funds have enjoyed huge runs in the past 18 months. That’s left many to wonder whether the sector offers additional upside and if investors are being adequately compensated for risk. This multi-sector bond fund is one that will continue to perform. –The Editors

High-yield bonds were the best performing fixed-income category in 2009, as funds structured around these instruments generated an average return of better than 46 percent.

This marked a sharp turnaround from 2008, when the market regarded any company relegated to the high-yield category as essentially bankrupt; high-yield bond losses for the year were exceeded only by bank loan losses.

The question now is whether high-yield funds have more room to run.

In recent testimony before Congress, Federal Reserve Chairman Ben Bernanke pledged that interest rates would remain low for an extended period. That’s good news for high-yield bonds.

But interest rates will inevitably rise. Dissent of the current 0 percent rates is building within the Federal Open Market Committee, and high-yield bonds tend to perform well during tightening cycles. When Treasury yields increased from 2.3 percent in June 2003 to 3.9 percent in June 2004, high-yield bonds gained 14.2 percent.

Finally, the overall economic environment continues to improve, and access to financing for speculative-grade credits is increasing along with profitability. This budding optimisim suggests that spreads will continue to tighten.

Unfortunately, most high-yield funds aren’t positioned to benefit from the confluence of these circumstances. Some will maintain their yields by moving into riskier assets, while others will generate solid capital gains but offer declining payouts. Right now, I only know of one fund that can both maintain its yield and book capital gains.

Despite last year’s huge run, 2010 should be another solid year for Carl Kaufman and Osterweis Strategic Income (OSTIX). The fund’s current portfolio consists primarily of lower rated bonds with shorter maturities. Kaufman also has upped his stake in convertibles—the prices of which behave more like stocks than bonds—to 14 percent, positioning the fund to benefit from further improvement in equities.

Kaufman has also shifted assets to foreign corporate debt. His largest holding is Millicom International Cellular 10 Percent Note of 2013—a typical Kaufman investment. This bond, like many of Kaufman’s holdings, is unrated.

Millicom International Cellular (NSDQ: MICC) is a leading provider of cellular phone service in emerging markets, one of the few areas of the world where cellular penetration rates have room to grow. The firm reported robust growth in Africa and South America and is now the leading provider in Honduras, Paraguay, El Salvador and Guatemala. The company’s cash flow provides ample coverage for debt service payments.

Despite solid positions in markets with growth potential, Millicom has failed to garner much attention from investors or any love from the credit rating agencies.

Millicom illustrates Kaufman’s strengths. By closely monitoring the broader economic picture and focusing on securities are good values, Kaufman holds a portfolio that offers an impressive yield without excessive volatility.

Although investors should avoid most high-yielding funds at these levels, Osterweis Strategic Income offers plenty of potential. –Benjamin Shepherd