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.