High-Yield Bond Funds -- First Quarter 2004 Review

April 1, 2004 — High-yield bond funds continued to move up in the first three months of 2004, but their momentum slowed as investors became wary of risks in the sector and began pulling money out.

Mutual funds that invest in high-yield, or so-called junk bonds, returned 1.5% in the first quarter after delivering a gain of 5.2% in the fourth quarter of 2003, and 23.2% for the full year.

Fund managers said the slowdown in the group represented a defensive response to its strong run over recent months, as investors worried that bond valuations had gotten too pricey.

“It was time for a little bit of a correction, a bit of a give back,” said Peter Ehret, co-manager of the AIM High Yield Fund/A (AMHYX).

Dana Erikson, who heads the high-yield group and manages two high-yield bond funds at Evergreen Funds, said, “I think what you’re running into this year is a natural reaction to any market that’s come as far as high-yield did” in 2003.

Junk bonds suffered outflows of $1.36 billion through March 24, versus inflows of about $8.6 billion in the same period a year ago, according to AMG Data Services.

That, in turn, pulled junk bond prices down a bit over all, although higher-quality issues have held their value better than lower-rated bonds, said Margaret Patel, who runs the Pioneer High Yield Fund/A (TAHYX).

Also, compared to a year ago, the difference in yields between 10-year Treasury bonds and junk bonds has narrowed to the point where investors are no longer getting sufficiently rewarded for the added risks they take in buying high-yield bonds, money managers said.

Referring to junk bonds, the gap in yields has “contracted so dramatically that I think you have to conclude that most of the opportunity for extraordinary total returns is behind you,” said David Joy, chairman of the capital markets committee for American Express Funds, which forecasts the performance of various asset classes.

Still, the junk bond sector remains fundamentally sound, fund managers said, as the factors that underpinned it during its growth spurt last year remain in place. Interest rates are low, as are default rates on high-yield bonds, and the economy appears to be strengthening, they noted. Rock bottom interest rates also are continuing to make junk bond yields more attractive compared to competing fixed-income investments, observers said.

Looking ahead to the end of the year, fund managers said they expect junk bonds to return 7%-8%, with most or all of the gains coming from yield rather than capital appreciation.