June 23, 2004 — While rising interest rates are generally bad news for bond funds, high-yield bond funds may provide opportunities, based on the potential for defaults. As the economy recovers, high-yield defaults tend to fall, benefiting high-yield investors. Since a rebounding economy usually drives interest rates higher but also lowers the rates of high-yield defaults, we reviewed high-yield funds in times of rising interest rates.

We looked at fund performance in two one-year periods of rising rates, 1994 and 1999. In addition, we reviewed these funds over the one-, two- and three-year periods after the year of climbing rates to see if there was any subsequent impact. We also looked at performance for the one-year period through May, when the yield on the 10-year Treasury rose from 3.35% to 4.66%. We reviewed 413 high-yield bond funds, including multiple share classes.

High-yield fund performance in 1994 and the three following years was just the opposite of that in 1999 and the following three years, as shown in Table 1 below. High-yield funds fell in 1994 as rates soared, but as rates dropped sharply in 1995 and remained in a narrower but lower range over the next three years, high-yield funds performed very well. However, they still lagged the Lehman High Yield (US Corporate) Index.

Conversely, in 1999, high-yield funds posted positive returns even as rates surged, and they outperformed the Lehman index. Over the following three years, however, high-yield funds performed poorly and badly trailed the Lehman index, despite a sharp decline in rates. So looking at interest rates wasn’t necessarily the best way to consider investing in high-yield bond funds.

We screened the 413 high-yield funds for those which outperformed the Lehman index over the past year and also outperformed in the one-, two- and three-year periods after 1999. The five funds in Table 3 below all outperformed in the years following 1999 even as high-yield funds declined. Looking further back, none of the funds screened with these criteria were able to also outperform in the periods after 1994. They either lagged the benchmark in one or more of those periods or they did not exist at that time.

Table 1: Interest Rates and Fund Returns for Periods of Rising Rates
1994 and After Dec. 31, 1993 Dec. 31, 1994 Dec. 31, 1995 Dec. 31, 1996 Dec. 31, 1997
10-Year Treasury Yield 5.78% 7.83% 5.57% 6.41% 5.74%
Performance Periods N/A One YearThrough 12/31/94 One-Year Through 12/31/95 Two Years Annualized Through 12/31/96 Three Years Annualized Through 12/31/97
High-Yield Fund Returns N/A -3.07% +17.18% +14.88% +14.17%
Lehman High Yield (U.S. Corp.) N/A -1.03% +19.17% +15.16% +14.36%
1999 and After Dec. 31, 1998 Dec. 31, 1999 Dec. 31, 2000 Dec. 31, 2001 Dec. 31, 2002
10-Year Treasury Yield 4.64% 6.43% 5.11% 5.03% 3.82%
Performance Periods N/A One Year Through 12/31/99 One Year Through 12/31/00 Two Years Annualized Through 12/31/01 Three Years Annualized Through 12/31/02
High-Yield Fund Returns N/A +4.88% -7.11% -2.86% -2.49%
Lehman High Yield (U.S. Corp.) N/A +2.39% -5.86 -0.44% -0.77%
Table 2: Interest Rates and Fund Returns Over the Past Year
May 31, 2003 May 31, 2004
10-Year Treasury Yield 3.35% 4.66%
Performance Period N/A One-Year Through 5/31/04
High-Yield Fund Returns N/A +10.96%
Lehman High Yield (U.S. Corp.) N/A +11.89%
Table 3: Funds Ranked by One Year Returns Through May 31, 2004
Fund Name One Year Through 5/31/04 One-Year Through 12/31/00 Two Years Annualized Through 12/31/01 Three Years Annualized Through 12/31/02 S&P Star Rank
Mason Street High Yield Bond Fund/A (MHYAX) +14.68% -3.57% +0.7% -0.64% 3
Goldman Sachs High Yield/A (GSHAX) +14.52% -4.40% +0.41% +0.08% 3
Diversified Inv Adv High Yield Bond/ Inv (DVHYX) +14.1% -4.44% -0.04% +0.54% 4
Westcore Flexible Income Fund (WTLTX) +13.57 +10.70% +8.42% +5.52% 4
One Group High Yield Bond/I (OHYFX) +12.82% -3.54% +0.81% +0.17% 3
Lehman High Yield (U.S. Corp.) +11.89% -5.86% -0.44% -0.77% N/A

Source: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Data as of 5/31/04.

Contact Robert F. Keane with questions or comments at: