There seemed to have been a lot of hype at the end of 1998 about how the place to be for 1999 was going to be in high-yield (junk) bonds or funds. Is this still the opinion of the advisers? How much money do they think can be made? What are the yields available now through funds? -- Joseph Ellebracht


While the real bargain-basement days are over for the high-yield market, junk bonds still are nowhere near as pricey as they were through the end of July, and the people who stake their reputations on this sort of thing continue to forecast outsized gains for the sector this year.

Value in the high-yield bond market is measured by how much excess yield the bonds offer over risk-free Treasury bonds, known as the spread. The wider the spread, the more value high-yield bonds offer. (High value doesn't mean low risk, however. In fact, it means just the opposite; spreads widen to compensate the investor for the risk that things will get even worse for the sector.) As measured by the

Merrill Lynch High-Yield Corporate Index

, high-yield spreads got as narrow as 313 basis points last year on April 28 before widening to as much as 680 basis points on Oct. 16. As of last night, the index spread to Treasuries was 542 basis points. The long-term average spread is about 375 basis points.

Based on expectations that the economy will continue to grow in the 3% to 4% range this year, market strategists are predicting total returns in the 8% to 11% range for high yield this year, compared to less than 1% last year as measured by most indices.

Goldman Sachs

is looking for returns in the 8% to 10% range.

Merrill Lynch

expects around 9%.

Salomon Smith Barney

is predicting around 10%. And

Bear Stearns

sees the sector returning 11%. (The other major firms wouldn't tell me what they're looking for.)

As for the yields currently available on high-yield bond funds, as of last Thursday the average fund was yielding 9.1%, according to


. (For any individual fund, you can use our

Tools of the Trade to draw a chart that will tell you its yield.)

Do Junk Bonds Move with Stocks?

I would like to know the correlation between junk bonds and stocks. Most gurus simply say that junk moves up and down with equities. Is this true, and if so, is there a quantitative correlation between stocks and junk bonds in up and down markets? -- Anna Maxes


Broadly, it's true. The performance of high-yield bonds is closely correlated with the performance of stocks, particularly in comparison with risk-free government bonds.

Analysts measure the correlation of total returns between asset classes using something called regression analysis. Basically, it generates a measure of correlation on a scale of negative 1 to 1. A correlation of 1 between two asset classes means they behave in a very similar manner (e.g., one goes up, the other goes up). A correlation of negative 1 indicates an inverse relationship (e.g., one goes up, the other goes down). A correlation of zero means there's no discernable relationship between the two.

Looking at the period of 1986 to 1998 (there was no meaningful junk-bond market prior to 1980),

Ibbotson Associates

calculates that high-yield bonds' correlation to the

S&P 500

was 0.49. Intermediate-term government bonds, by contrast, had a correlation coefficient of 0.25.

As important, however, as the overall analysis is a look at the performance of the S&P 500 month by month to determine how the correlation changes with the performance of the stock market -- in answer to your question about up vs. down markets.

According to analysis by Ibbotson research consultant Gary Baierl, in months when the S&P 500 returned more than its monthly average for the period, high-yield bonds' correlation was 0.24, while the government bonds' correlation was 0.29. But in months when the S&P returned less than its monthly average for the period, high-yield bonds had a 0.49 correlation, while the government bonds' coefficient was negative 0.06. Bottom line: High-yield returns are more closely correlated to stock returns than government bond returns, but they are more correlated to stock returns when stocks are doing poorly than when stocks are doing well.

Why is this so?

Moody's Investors Service

economist John Puchalla says rises and falls in high-yield bonds' correlation with large-cap stocks appear to be related to changes in the short-term interest rates controlled by the


. In periods when the Fed is lowering the fed funds rate to stimulate the economy (which typically benefits stocks), the correlation falls. When the Fed is raising rates to curb growth (which typically hurts stocks), the correlation rises.

It makes sense that the correlation would drop during periods when the Fed is easing, Puchalla says, because falling interest rates suggest earnings trouble ahead for companies, and earnings trouble is a bigger issue for the smaller companies that issue junk bonds than it is for large-cap companies.

"High-yield bonds are acutely earnings-sensitive, which means even if rates are falling, spreads may widen," he says. "So overall, the increase in high-yield might not be that dramatic." Ironically, in this scenario interest-rate cuts are more beneficial to the stocks than to the bonds.

Likewise, when the Fed is raising rates, presumably because the economy is cooking, the earnings outlook is probably improving. That should tighten the spreads on high-yield bonds, even as rising yields erode some of their value. Again, ironically, rising rates may hurt the bonds less than the stocks.

And it makes sense that high-yield bonds' correlation with large-cap stocks is stronger when stocks are doing poorly than when they're doing well, Puchalla says, essentially because high-yield bond investors react in a bigger way to bad news than to good news. In other words, high-yield spreads widen more quickly when the earnings outlook is deteriorating than they narrow when the outlook is improving. "When the economy is improving, spreads would be narrowing, but maybe not as dramatically as they would be widening in a downturn," the economist says.

Having said that, it's important to recognize that huge changes have swept the high-yield bond market since its inception in the early '80s, changes that suggest that forming expectations based on the past may not make much sense.

Without going into too much detail, the high-yield bond market began as primarily a financing tool for leveraged buyouts, collapsed in 1989 and 1990, and has been rehabilitated as a source of capital for small- and mid-cap companies.

"The high-yield asset class has changed so dramatically since the mid-1980s, even over the last five years, that it's tough to make any kind of generalization," says Ben Kao, high-yield market strategist at

Goldman Sachs

. He says Goldman's research on this topic concluded that, over the long term, the high-yield market "isn't that correlated with the S&P to any meaningful degree."

Much of what you heard about the close correlation between high-yield bonds and stocks may have been articulated during the first seven months of last year, when Kao says the correlation reached 0.92. But since the market's October collapse, the correlation has fallen off sharply as investors have become more selective about which high-yield bonds they buy, he says.

Elizabeth Roy answers your bond fund questions on Friday. Dagen McDowell answers general mutual fund questions Monday through Thursday. Send questions on their topic to, and please include your full name.

TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.