Cooling Down

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.