Morningstar.com
Not So High Times for High Yield
Wednesday February 20, 7:00 am ET
By Scott Berry, CFA


In mid-2002, most high-yield bond funds offered yields in the 8%-10% range and most diversified investment-grade bond funds offered yields in the 4%-6% range. In an article posted on Morningstar.com in May of that year, I wrote how the high-yield market looked friendlier than it had in quite some time. Yields are now back in those same ranges, but I don't have the same positive feeling about the junk-bond market.

In 2002, the default rate was dropping and the economy was improving. We have just the opposite shaping up for 2008. The default rate remains historically low, but Moody's predicts that it will jump from 1.1% to 4.6% by the end of the year. Others predict slightly higher or lower default rates, but the overwhelming consensus is that defaults will increase, as the economy fights to stave off inflation and companies look to refinance debt in a tight credit environment. The economy grew in the fourth quarter of 2007 but at an anemic pace. And while the Federal Reserve has cut interest rates in an effort to spur growth, it will take time for those cuts to have an impact on consumer spending and the economy. Meanwhile, the housing market remains a big concern, as falling home values and rising adjustable-rate mortgage payments have sent many homeowners into foreclosure.

It's no wonder that the spread or difference between junk-bond yields and Treasury yields has soared over the past year--investors are simply demanding more yield in return for more risk. But are they demanding enough yield? The average high-yield bond fund yields around 8%. If defaults knock the average fund's return down a percentage point or two, and if yield spreads widen a bit more, high-yield investors might be left with a 2008 total return in the 4%-5% range. In short, the seemingly large yield advantage offered by junk-bond funds could easily be negated by capital losses.

Unfortunately, bond investors who are looking for added yield have few other options. Bank loans typically offer a lower-risk alternative to junk bonds, but falling interest rates have worked against them, as their interest rates float higher and lower with market rates, and defaults could also strike here. On the plus side, bank-loan yields adjust with the market so an interest-rate spike will be much less painful for bank-loan funds than other funds that invest in bonds with a set interest rate. And the pummeling that loans have taken recently have made them look a bit more attractive than they had a few months back.

We've heard from intermediate-term bond-fund managers who are finding good values and great yields in higher-rated subprime mortgages, but I expect that most will continue to tread lightly there. Multisector-bond funds are one area that could offer some opportunity. They typically yield less than high-yield bond funds, but their broad diversification and sometimes considerable flexibility could work in their favor over the next year. The ability to shift allocations around based on the relative values of the different bond market sectors could prove quite valuable in a volatile market environment.

So, although junk bonds have become increasingly attractive from a yield standpoint over the past year, now may not be the best time to be piling into that area of the bond market. I remain a long-term fan of high-yield bonds and continue to hold a high-yield investment of my own, but those looking to enter the market should keep expectations in check. And they may want to lean toward the category's more restrained options, such as Vanguard High-Yield Corporate (NASDAQ:VWEHX - News), T. Rowe Price High-Yield (NASDAQ:PRHYX - News), and PIMCO High Yield (NASDAQ:PHYDX - News). I'd expect all three to hold up relatively well if the market continues to struggle.

Scott Berry, CFA does not own shares in any of the securities mentioned above.