January 3, 2006

Cooling Down

High-Yield Bond Funds -- Year-End 2005 Review and Outlook

Mutual funds that invest in high-yield bonds were limping to the finish line late in the fourth quarter as they headed to end the year in the black, but not by much.

Looking ahead, money managers and others expect the sector to generate modest gains in 2006.

Through December 19, the average junk bond fund was up 0.4% for the quarter and 2.3% for the year, preliminary data from Standard & Poor's showed.* Junk bond funds gained 9.6% in 2004, and 24.3% in 2003.

By the end of next year, David Wyss, chief economist for Standard & Poor's, said he sees total returns for short-term junk bonds clocking in at 5%-7%. (High-yield bonds typically mature in two to five years.) Junk bonds with maturities of 10 years or more could end the year flat, he said.

Mark Vaselkiv, who runs the T. Rowe Price High Yield Fund (PRHYX), was slightly more pessimistic. "I think the first six months will be a bit choppy, maybe a little sloppy," he said. Vaselkiv believes bonds could break even during that span and then rebound to end the year up by 5%.

Similarly, Margaret Patel, the manager of the Pioneer High Yield Fund (TAHYX), forecast low to mid single-digit returns.

Observers attributed weakness in junk bonds this year to relatively paltry yields and volatility stemming from General Motors (GM) and Ford Motor (F) entering the high-yield market when their credit ratings were downgraded in the spring. (See Automakers in the Junkyard: Will Bond Markets Cope? in Research & Insights section of Fund Advisor.)

But, as they have over the last two years, junk bonds were helped by the healthy economy and corporate profits, as well as low inflation and interest rates. Observers expect those factors to continue to underpin the sector in 2006.

High-yield bonds also have done well in recent months and years because default rates have shrunk. The pace at which companies fail to meet their junk bond obligations is expected to increase in 2006, but defaults should remain below their historical norms, observers said.

Standard & Poor's forecast in early December that U.S. default rates for speculative-grade bonds would edge up slowly in the next few quarters and reach 2.8% by the third quarter.

Within the junk bond investment universe, Wyss and Vaselkiv think the telecommunications and technology sector may do well in 2006. These companies' "profits are looking very good," said Wyss, adding that they should also get a leg up as companies upgrade their telecom and computer systems.

Vaselkiv said he likes wireless telecom companies because they generally have been gaining more subscribers and generating good free cash flow. The fund manager said he also likes energy companies, which have benefitted from high oil and gasoline prices. Vaselkiv thinks these businesses will do well even if oil prices drop by as much as $10-$15 a barrel.

Patel, on the other hand, predicted only "muted growth" for technology and telecommunications companies in the coming year. Companies of this kind that offer junk bonds tend to be small, so they are vulnerable to larger rivals, price competition, and technological change, she said.

Looking to 2006, Patel said she favors businesses that stand to do well if the U.S. economy keeps growing, like chemical companies, and those that produce construction materials.

High-Yield Bond Funds

Best Performers

Fourth Quarter 2005 Returns (%)

Worst Performers

Fourth Quarter 2005 Returns (%)

J Hancock High Yield/A (JHHBX)

+2.6

Access Flex Bear High Yield/S

-2.1

Access Flex High Yield/I

+2.5

Potomac High Yield Bear/Inv. (PHBRX)

-1.5

Potomac Dynamic High Yield Bond/Investor (PDHYX)

+2.1

First Investors Fund for Income/A (FIFIX)

-1.0

WM High Yield/A (CPHYX)

+1.7

Evergreen High Yield Bond/B (EKHBX)

-1.0

Franklin AGE High Income Fund/Adv (FAHAX)

+1.4

Westcore Fds Flexible Income Fund (WTLTX)

-1.0

High-Yield Bond Funds

Best Performers

2005 Returns (%)

Worst Performers

2005 Returns (%)

Highland Floating Rate Advantage Fund/A (XSFRX)

+7.2

Potomac Dynamic High Yield Bond/Investor (PDHYX)

-5.6

Regions Morgan Keegan Sel High Income/I (RHIIX)

+7.1

AFBA Five Star High Yield/C (AFHCX)

-2.3

Integrity High Income Fund/A (IHFAX)

+6.8

First Investors Fund for Income/B (FIFJX)

-2.0

SunAmerica High Yield Bond Fund/Z (NHIIX)

+6.7

Buffalo High Yield Fund (BUFHX)

-1.0

Summit High Yield Bond Fund (SAPHX)

+6.6

Mason Street Fds High Yield Bond Fund/B (MHYBX)

-0.7

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