Jan. 5 , 2004 — Funds that invest in high-yield bonds ended the fourth quarter of 2003 and the year on an upbeat note.

Helped by the economic recovery, the average junk bond fund returned 5.2% between October and December, and 23.2% for the full year, according to data from Standard & Poor’s.

“In general, the high-yield market today remains very, very healthy,” said Matthew Freund, who manages the USAA Mutual Fund:High Yield Opportunities (USHYX).

The improving economy enabled companies to reduce debts, thus bolstering their credit ratings and giving investors confidence that junk bonds would get paid off.

Default rates on the securities fell to about 5% last year from nearly 10% in August 2002, and are expected to continue declining in 2004, industry observers said.

Junk bonds also got a boost because low interest rates made competing fixed-income investments look less appealing by comparison, money managers said.

“On the mutual fund side, clearly there were folks saying, well, look, I’m not earning enough on my money market or my short-term bond funds, so I have to extend down the risk scale,” said Freund.

Looking ahead, junk bond fund managers said they are optimistic about prospects for the high-yield sector in 2004. The factors that worked to its advantage last year should continue to support it, they say.

Although interest rates are expected to begin creeping higher this year, junk bonds should hold up better than many fixed-income investments in that environment, observers said. Mark Vaselkiv, who manages the T Rowe Price High Yield Fund (PRHYX), noted that the performance of lower quality bonds depends more on underlying company fundamentals than interest rates.

However, money managers cautioned that the difference in yields between high and low quality bonds has narrowed, so junk bonds are not as compelling an investment as they were a year ago.

While junk bond managers said a repeat of last year’s returns is very unlikely in 2004, they expect to see relatively attractive junk bonds yields of 7%-9%.

“It probably will be a coupon clipping market,” said Richard Cryan, who oversees the Evergreen Select High Yield Bond/I (EHYIX).

– Richard Diennor