High Tide for High Yield

John Lonski, chief economist at Moody's, echoes Berry's forecast for 2004: "We are not going to see the 24% total return from 2003 again soon, due to the narrowing of spreads. At best, it will be a flat year and investors will just collect a yield of 7% to 9%."

For investors still looking for high-yield exposure, Berry suggests the (PHDAX)PIMCO High Yield fund, the (NTHEX)Northeast Investors High Yield fund and the (EVIBX)Eaton Vance Income fund. He also recommends interested investors take a look at the newly reopened Vanguard High-Yield Corporate fund.

Berry likes the PIMCO and Vanguard funds because of their more conservative approach; both funds rarely delve into truly speculative bonds rated below B, which are considered high-risk investments, even in the high-yield world. He also admires their extensive research capabilities, which he views as a necessity in the high-yield fund world.

"Analyzing high-yield bonds is all about tearing apart balance sheets and delving into the details of the issue and the issuer," says Berry.

Size Does Matter

The stellar returns of high-yield bonds in 2003 were not purely a function of an improving economy, which enabled issuers to increase profits and clean up balance sheets. Nor was it simply an overreaction by investors tired of low Treasury yields. Good old supply and demand played a healthy role in the run-up of high-yield funds.

"Prices appreciated because of the lack of inventory as well," says Lipper Analyst Martin Vostry. "Investors were chasing yield and the high-yield market has a smaller number of issues compared to Treasuries, large-cap stocks or even investment-grade bonds."

According to Morningstar, the average high-yield fund holds $1.4 billion in assets, making Vanguard's fund ($9.5 billion) and PIMCO's fund ($8.2 billion) the major players.

As would be expected from the cost-conscious fund giant, Vanguard offsets the lower yield that comes from avoiding highly speculative, CCC-rated issues by maintaining a 0.26% expense ratio. The Vanguard high-yield fund has no front- or back-end sales load. PIMCO's high-yield fund, by comparison, carries a 4.5% front-end load on top of a 0.9% expense ratio. (The average expense ratio for a no-load, high-yield bond fund is 0.86%, while front-end loaded funds run an average expense ratio of 1.13%, according to Morningstar.)