Successful bargain hunters typically outfox their competitors by arriving early on the day of a big sale. Likewise, deal-seeking investors who started shopping in early 2003 for high-yield bond funds brought home the lowest prices and the highest yields. Those investors who owned high-yield funds the entire year were rewarded for their diligence with an average return of 24.04%.

On the other hand, investors who arrived late to the market found themselves caught in a stampede of yield-starved investors running from the 10-year Treasury note. In June of 2003, the ( VWEHX) Vanguard High-Yield Corporate fund closed its doors to new investors after being overrun with new, and possibly hot, money.

Now that the great yield rush has ended, the prevailing view among analysts is that high-yield bonds, or what are sometimes called "junk bonds" because the corporate debt is considered to be a higher credit risk, are "priced to perfection." But does that mean it's time for savvy shoppers to start looking for bargains elsewhere?

Priced to Perfection

Most analysts agree that over the last year to 18 months, much of the capital appreciation in the high-yield market has been wrung out. According to the Lehman Brothers high-yield index, the spread between high-yield bonds and the 10-year Treasury bond shrank from 842 basis points, or 8.42%, on March 10, 2003, to 439 basis points, or 4.39%, on March 8, 2004.

The tighter spread begs the question as to whether investors are willing to stomach the additional risk involved with high-yield bonds in return for the slim reward of earnings just 4.39% above a 10-year Treasury note, now hovering in the 3.75% range.

Morningstar Analyst Scott Berry agrees that the high-yield market is probably "priced to perfection," but in today's low-yield environment, Berry says yield-seeking investors have few alternatives.

"You are getting very little yield from diversified bond funds," says Berry. "So just taking home the 6% to 7% yield from high-yield funds may be attractive."

Littered With Junk Bonds
U.S. High Yield Issuance (in billions)
2004 $30.9*
2003 131.2
2002 58.8
2001 78.9
2000 42.7
1999 92.7
* Through March 12. Source: Bloomberg

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.)

Vanguard's size worked against it last June, when short-term investors overran the fund, looking for a high-yield place to park their money. In a highly responsible move, the fund's board closed the fund to new investors to protect long-term shareholders. The fund reopened in December 2003, when fund manager Earl McEvoy felt the coast was clear.

T. Rowe Price, another giant of the industry, closed its ( PRHYX) T. Rowe Price High-Yield fund to new investors when the fund reached $4 billion in February 2004.

The big risk to a market that's tight on inventory is a glut of new issues hitting the market and knocking down prices. Analysts are afraid that overissuance might be a factor behind the market's slow start in 2004. According to Morningstar, high-yield funds year to date are only up an average of 1.4%, after a scorching 2003.

Sean Michael Slein, high-yield portfolio manager for Dwight Asset Management, confirms that a recent wave of highly speculative new issues -- even for junk bond standards -- has chilled the once hot market. Slein says the rise in CCC-rated issues to a historically high 20% of the total market is evidence that the frothy market has emboldened companies to litter the Street with low-quality paper.

Slein says today's environment is a far cry from the fall of 2002, when new issues were just hitting the market and the spread was over 900 basis points.

"The market was closed due to corporate scandals until the fall of 2002," says Slein. "Then Warren Buffett came in, the Fed grew accommodative and deal flow started increasing through the winter of 2003."

Over the course of 2003, Slein says he witnessed spreads getting tighter and tighter as both credit quality improved and more new deals came to market, especially in power sector names like Calpine ( CPN) and Dynegy ( DYN).

Last July, Calpine was criticized for bringing a $3 billion issue to a saturated market. Earlier this month, Calpine came out with an additional $2.5 billion issue.

Tom Huggins, high-yield portfolio manager for Eaton Vance, does not see the influx of new issues rattling the markets too much because of the improved credit quality of the names. Huggins' fund returned 29.4% in 2003 through aggressive trading and a canny ability to choose winning CCC-rated bonds, especially in a telecom sector that was once left for dead.

"I think the quality of paper is very strong now and the asset class is not made up of Internet stocks with poor credit," says Huggins.

Whose Default Is It?

Most likely, the market will learn the true quality of the current wave of high-yield debt in three years. According to Martin Fridson, publisher of Leverage World, an independent high-yield strategy publication, default rates historically lag new issues by three years since "very few companies miss their first few coupon payments."

Like Slein, Fridson also sees a growing glut in the CCC range in today's market and is expecting default rates to rise in 2006-2007.

For the time being, Fridson is in the "priced to perfection" camp, but still sees high-yield bond funds as preferable to other fixed-income investments, especially in a rising interest rate environment.

"A sudden rise in short-term interest rates would cause the bond market as a whole to be hurt, but high yield would do better because the yield would cushion the fall. Long-term treasuries would fare the worst," says Fridson. "Higher interest rates might be a positive because that means there is faster earnings growth in the economy, and the economy is the most important element in high-yield debt."

For his part, Eaton Vance's Huggins is telling clients to disregard all the flak about high-yield bond prices being "priced to perfection," because prices, like performance, are all relative.

"Clearly, nobody would argue that high yield is as compelling as it was a year ago, but I think you can expect the coupon of around 8%, and I don't think that looks bad on a risk-adjusted basis vs. equities. If we make some good moves, we might make a 10% total return, which is still pretty good."

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