Hopeful on High-Yield Bonds

Two years of outperformance haven't dampened expectations for junk bond funds.
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High-yield bonds are looking like a high-wire act for 2005.

Funds specializing in so-called junk bonds, or noninvestment-grade corporate debt, saw their second straight year of outsize returns in 2004. Investors in these funds can thank a recovering economy and an accommodative

Fed

.

Two straight years of strong returns, along with widespread predictions that interest rates will rise, are making some junk bond holders anxious. And

Pimco

manager Bill Gross' claim that cash is looking better than bonds of all stripes for 2005 isn't helping to soothe any rattled nerves either.

Even so, some analysts are telling investors to expect another "solid, if unspectacular" year.

"Don't sell high-yield until you see the whites of the eyes of recession," says Greg Hopper, portfolio manager for the

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Julius Baer Global High Yield fund. "And we are not close to seeing that yet."

Recession snuffed out the high-yield market in 2001 and 2002, when the staggering economy made it difficult for cash-strapped companies to meet big coupon payments. GDP growth slowed to less than 1% in 2001 and just under 2% in 2002. As a result, high-yield defaults rose to record levels in those years, hitting a high of 10.9% in January 2002, according to Moody's.

The ensuing recovery boosted high-yield returns to equitylike levels, though -- much of it from capital appreciation as opposed to yield. According to Morningstar, high-yield fund returns averaged 24% in 2003 and 9.8% last year, nearly on par with the

S&P 500's

gains. Default rates have since dropped to 2.5%. And economists expect GDP growth to be in the mid-3% range for 2005, which fund managers say bodes well for economically sensitive high-yield issues.

"High-yield should be one of the best performing fixed-income asset classes in 2005," says Kathleen Gaffney, portfolio manager for the

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Loomis Sayles Bond Return fund. "It's mostly going to be coupon-clipping since much of the capital appreciation has been wrung out, but it still beats Treasuries by a long shot."

Among the names Gaffney likes are high-yield issues from downtrodden tech companies like

Lucent

(LU)

,

Corning

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and

Xerox

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.

The average current yield for high-yield funds is close to 7%, according to Morningstar. That's about what most analysts see high-yield funds returning in 2005. And if that seems paltry after the last couple of years, observers note that the 10-year Treasury is yielding less than 4.25%.

Hopper says high yield has a number of factors going for it that should give coupon-clippers some confidence. He cites high corporate cash levels, which should help issuers stay current on their debt payments even if the economy sours, and improving technicals. By this he means that new issues are being used to refinance and retire existing debt, holding supply down.

Hopper likes emerging markets bonds denominated in local currencies. He especially likes Turkish T-bills, which are yielding 22%. "Historically the Turks have a high inflation rate and volatile currency, but these are being worked on so they can get into the European Union," says Hopper.

Despite the favorable economic environment for high-yield, analysts still caution investors to tread carefully in what can be a volatile asset class. Says Martin Fridson, publisher of high-yield newsletter

Leverage World

, "Default rates are not projected to go up a lot and interest rates are not going up too quickly, so you can still do well in high yield -- but you need to be prepared for the principal to bounce around."

For this reason, most financial advisers limit their clients' exposure to high-yield funds. Mary Rinehart, a financial adviser with North Carolina-based Rinehart & Associates, says she keeps less than 5% of her clients' overall assets in high-yield and is quick to sell when storm clouds appear on the economic horizon.

"High yield is a wonderful avenue if we are coming out of a recession," says Rinehart. "But if there is a hint of a recession, I usually get out quickly because junk bonds are the first to fall when things turn south."

Weighing in on the cautious side is Morningstar high-yield analyst Scott Barry, who says investors should be especially careful this year because "after two strong years in a row, much of the capital appreciation potential has been wrung out of the market, and if defaults rise, then investors might not even see the full coupon."

Barry's top high-yield fund choices are

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Northeast Advisors because its selections are "issue specific as opposed to market specific" and

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Vanguard High-Yield Corporate, due to its low volatility and low expense ratio of 23 basis points. The average expense ratio for a high-yield fund is 1.31%, according to Morningstar.