Not-So-High Hopes for High Yield

High-yield bond funds have bounced back nicely in recent weeks after a summer slump that saw many funds lose 4% or more. The junk-bond market wasn't hit by a wave of defaults in June and July. But with the subprime mortgage problems working their way through the market, investors shifted assets into higher-quality bonds or simply demanded more yield in return for the added risk of junk bonds. The upshot was higher yield spreads (the difference in yield between junk bonds and Treasury issues) and lower prices. A rate cut by the Federal Reserve soothed frayed nerves, however, and helped most junk-bond funds get back on track. The average fund has now returned 3.7% for the year to date.

The recent market volatility has created numerous opportunities for skilled managers to add value, but many are sounding increasingly nervous about the market's prospects. One concern is the default rate. Defaults have been a non-issue in recent years, as a healthy economy and strong cash flows have helped issuers service their debts. But Moody's expects the default rate to climb in 2008 and 2009, as issuers struggle to refinance debt. And a higher default rate will likely push spreads wider, as investors will look to be compensated for that added default risk. Along those same lines, we're hearing concern about the huge amount of CCC bond issuance that has come in recent years. Many CCC issuers were likely banking on economic growth to help them grow their business and finance their debt. A slowing economy could mean added trouble for many of them.

It's also important to keep in mind the asymmetrical return profile of junk bonds. When all goes well, the bonds mature at par. When things don't go well, investors can be left with just pennies on the dollar. So while there can be good return potential when bonds are priced at $0.80 or $0.90 on the dollar, there is considerably less potential when bonds are priced at or above par, as many of them are now. And not only do the bonds have less potential for gains, but we're hearing from some managers that there is more potential for losses, as bank loans will be first in line to get paid if something goes wrong.

On the plus side, the Federal Reserve looks poised to do its part to keep the economy growing by lowering interest rates. Junk bonds are typically less interest-rate sensitive than higher-quality issues, but lower rates are better than higher rates. And if lower rates keep the economy on track, that will be good news for junk-bond issuers. Also, the recent  General Motors (GM) - UAW agreement improves the outlook for the automakers, which now play a major role in the junk-bond market and in many high-yield funds.

Still, investors expecting anything more than the yield on their fund could be disappointed, and they should brace for less. With yields in the 7.5% to 8.0% range, that could mean just a mid-single-digit total return over the next 12 months. That's not bad considering the 10-year Treasury is yielding just 4.6%--but it's not close to the 11.5% the average high-yield fund has gained over the past five years.