July 6, 2004

High-Yield Bond Funds -- Mid-Year 2004 Review

July 1, 2004 -- What has driven the performance of the high-yield bond market over the last three months?

"I think, in a nutshell, it's been interest rates," said Mark Vaselkiv, the portfolio manager of T Rowe Price High Yield Fund (PRHYX).

When rates increase, investors get defensive. Still, junk bonds should hold up better than other fixed-income investments if rates continue rising, provided they increase because the economy is strengthening, not to combat inflation, Vaselkiv said. Mutual funds that invest in junk bonds have "done relatively well in this environment," he added.

The average high-yield bond fund lost 0.8% in the second quarter. But the group managed to return 0.9% through the first half of the year.

Fund managers interviewed late last month, before the Federal Reserve nudged the federal funds rate to 1.25% from 1% Wednesday, said they did not expect the hike to move the high-yield market because the increase was already reflected in bond prices.

However, rising rates often lead people to sell stocks and bonds, noted Michael Praplaski, who heads the credit research team in Vanguard Group's fixed-income group. Junk bond funds have suffered redemptions in recent months. They saw outflows of $1.8 billion in April and $4.9 billion in May, according to Financial Research Corp.

More recently, high-yield corporate bond funds saw a $70 million outflow in the week ended June 23, marking the tenth week of outflows in the past 11, AMG Data Services reported.

In addition to rising interest rates, the sector has also continued to be hurt by profit taking following its strong performance last year.

Junk bonds did so well in 2003 that it's not "unnatural for the market to get a little bit tired, because valuations are no longer as compelling" said Praplaski.

On a positive note, the healthy economy is continuing to underpin the high-yield sector by improving companies' finances, enabling them to pay off debt, fund managers said.

"People are looking at improving underlying credit conditions in the market," said Dana Erikson, who heads the high-yield group and manages two high-yield bond funds at Evergreen Funds. That's why junk bond funds were able to post "at least somewhat positive" returns in the second quarter, he said.

"The view that the economy is going to do well for the foreseeable future is an absolute necessity for the high-yield market," said Thomas Price, the director of corporate fixed income investments for Strong Funds.

The sector has also been helped by declining corporate defaults and rising corporate profits, observers said.

Peter Ehret, co-manager of AIM High Yield Fund/A (AMHYX) said junk bonds have also been supported by foreign investors, as well as a lack of new investment-grade bonds.

"If there isn't much paper available in high grade land, (investors) tend to push down the credit spectrum," Ehret said. That, in turn, "creates interest in the higher quality high yield paper," he said.

Looking ahead to the next six months, money managers said they have lowered their outlook for the high-yield sector because they expect interest rates to push higher. Fund managers, who had been forecasting total returns of 7%-8% for the year, now say they expect junk bond funds to gain 4%-7%.

"It will be a plodding kind of environment, where people who outperform may make eight or nine percent, and people who don't may make six or seven," said Diane Keefe, who runs Pax World High Yield Fund (PAXHX). "It really does depend on how interest rates go, and how the economy goes."

High-Yield Corporate Bond Funds

Best Performers

Second Quarter 2004 Returns Through 06/30/04 (%)

Worst Performers

Second Quarter 2004 Returns Through 06/30/04 (%)

Delaware Pooled Tr:High Yield Bond (DPHYX)

+2.1

J Hancock High Yield Fund/B (TSHYX)

-4.2

Credit Suisse Instl High Yield (RBSFX) Credit Suisse Instl High Yield (RBSFX)

+1.4

Loomis Sayles High Income/C (NEHCX)

-3.5

Northeast Investors Trust (NTHEX)

+1.3

WM High Yield/CMerrill Lynch US High Yield Fund/A (MDCHX)

+1.1

Westcore Fds:Flexible Income Fund (WTLTX)

-2.8

Eaton Vance Advisor Senior Floating Rate (EAFRX)

+1.0

Pioneer High Yield/B (TBHYX)

-2.7

High-Yield Corporate Bond Funds

Best Performers

Mid-Year 2004 Returns Through 06/30/04 (%)

Worst Performers

Mid-Year 2004 Returns Through 06/30/04 (%)

Regions Morgan Keegan Sel High Income/I (RHIIX) +5.9 Loomis Sayles High Income/C (NEHCX) -2.3
Northeast Investors Trust (NTHEX) +5.4 J Hancock High Income Fund/C (JCHIX) -1.5
Delaware Pooled Tr:High Yield Bond (DPHYX) +5.1 Hartford High Yield Bond Fund/B (HAHBX) -1.4
Credit Suisse Instl High Yield (RBSFX) +4.6 PIMCO Funds:High Yield/B (PHDBX) -1.3
Delaware Group:High Yield Opportunities/I (DHOIX) +3.3 AAL High Yield Bond Fund/B (BBHYX) -1.2

Source: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends. Data as of 6/30/04.

Contact Robert F. Keane with questions or comments at:

bkeane@ia-mag.com.

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