Junk bond returns may be in double digits before too long.

After five years of flat or negative returns, high-yield bond fund managers expect that their funds will at least earn their coupons, which are about 9%, this year. But total returns could soar into the double digits when the economy improves, and for yield-hungry investors that could turn out to be a once-in-a-decade opportunity.

Over the past three years, high-yield bond funds have performed about midway between stocks and investment-grade corporate bonds. The average high-yield bond fund lost 2.8% annually in the three years ending December 31, 2002, according to Morningstar Inc., Chicago. By contrast, the Lehman Brothers Aggregate bond index grew at a 10% annual rate and the S&P 500 lost 14.6% annually.

On a positive note, high-yield bonds have acted independently of both the stock and bond markets. High-yield bond funds sported an R square of 0.28 to the S&P 500 and 0.18 to the Lehman Brothers Aggregate Bond index. Only a small portion of the volatility of either the equity or bond market contributed to the volatility of the high-yield market.

"High-yield bonds are a beast unto themselves," says Mark Durbiano, manager of the Federated High-Yield Trust. "The meltdown in equities over the past few years hasn't affected high-yield bonds all that badly. High-yield bonds have low correlations. But they may take their cue from the equity or bond markets."

A sluggish economy and a record number of bond defaults contributed to the 2002 malaise. Last year, a number of investment-grade credits, such as Tyco, Qwest, WorldCom and Georgia Pacific, became junk bonds.

High-yield issuers remain highly leveraged. In the past, they reduced debt by issuing stock. But that hasn't been an option over the past few years because the demand for initial public stock offerings has dwindled. Banks cut their lending. And many companies with capital expenditures had trouble servicing their debts.

Defaults on high-yield bonds were more than 12% in 2002. This year, the default rate has dwindled to 8%, according to Moody's Investors Service, New York. That's still double its historical average of 4%.

Today, however, fund managers say the excess has been squeezed from the market. The default rate is declining. Many companies have cut costs and strengthened their balance sheets.

The big question is when will the economy and stock market head north? Margaret Patel, manager of the Pioneer High-Yield Fund, estimates that high-yield bonds could register a total return of around 10% this year, but a lot depends on how the economy performs. If the economy grows and consumer spending picks up steam, high-yield bonds should perform well. "The atmosphere is one of fairly muted growth, not dynamic sector growth," Patel says. "The best high-yield companies are ones with stable operations, modestly increasing revenues and reasonable liquidity on the balance sheet."

She adds that we might have to wait until mid-year when Uncle Sam's economic stimulus and the tax cut kick in. Patel owns companies that are leaders in stable, expanding industries. They must have unique products and stronger balance sheets and cash flow than their peers. The companies show moderately increasing revenues and cash on the books, a critical indicator in an arena where the biggest fear is running out of cash.

The fund's largest sector holdings include nonconsumer cyclical, capital goods and basic industries. The largest holdings include Ivax Corp., a generic drug company with growing sales; Crescent Real Estate, which has strong demand for its Texas properties; and Freeport-McMoRan, which is benefiting from the rising cost of gold. Largest industries include capital goods, industrial products and services.

Going forward, fund managers say strong, sustainable economic growth should result in double-digit returns. "Balance sheets are getting strong and new issuance looks stronger," says Kevin Akioka, manager of the Payden & Rygel High-Yield Bond Fund. "Yield spreads are attractive, and companies are deleveraging."

Akioka says that this new focus on deleveraging is making the high-yield bond market much stronger today. "The valuation and yield spreads on bonds are high enough so that strong economic growth isn't necessary for the bonds to perform well."

Akioka's fund is overweighted in homebuilders, gaming, paper and forest products and health care. The fund's average holding is rated BB-. Like many managers, he favors lower-rated issuers instead of fallen angels. The reason: Many fallen angels have weaker bond covenants than bonds initially rated B. Plus, many B-rated issuers are using cash flow to pay down debts.

Some of his fund's largest holdings include Allied Waste, the country's second-largest waste management company, and Williams Scotsman, the country's second-largest mobile office and storage company. Allied Waste bonds yield 10%. The company has solid cash flow and is paying down debt. Meanwhile Williams Scotsman's bonds yield 12%. Cash flow is stable and growing.

Despite improving fundamentals, not all managers are sanguine about the market. James Caywood, manager of the Enterprise High-Yield Bond Fund, believes that the economy may slip back into a recession. Later this year, it should recover and grow at a 3.5% rate. "The uncertainty of war is leading to slower consumer spending and continued pressure on profits and corporate financial strength," he stresses.

Although most fund mangers stick with B-rated issues because the yield spreads are at historical highs in relation to Treasuries, Diane Keefe, manager of the Pax World High-Yield Portfolio, is playing it safe and is sticking with upper-tier credits. "I intend to manage with a conservative bias in an effort to reduce volatility and protect against the downside that could arise from a U.S.-Iraq military conflict," she says.

On the plus side, if the stock market performs well, high-yield bonds follow suit. Even if the stock market remains flat, high-yield rates look attractive. But if the economy slows and stocks decline, high-yield bonds may continue to underperform Treasury and high-grade corporate bonds, as they have for the past two years.

The total return on high-yield bonds typically has done well following a bear market in stocks, according to research by the No-Load Investor, an Ardsley, N.Y., newsletter.

The average diversified equity fund lost 26% in the September-to-November bear market of 1987. Over the next year, stock funds gained 21.5% and high-yield bond funds gained 11.9%.

In the July-to-October 1990 bear market, the average stock fund lost 18.3%, and gained 36.8% over the next year. High-yield bond funds lost 9.1% and gained 27.7% over the next year.

Bruce Monrad, manager of Northeast Investors Trust, says that relative to Treasury bond yields, high-yield bonds look good. The problem: Junk bond yields have been falling along with interest rates. So he's investing in issues that pay higher yields but still have acceptable cash flow and asset coverage. "The absolute levels of high-yield bonds to Treasuries are worrying," he says. "People are not used to buying 6% junk bonds."

Monrad is investing in California utilities because they represent good values. He owns Pacific Gas & Electric and Edison International. He also favors energy, natural gas companies and entertainment companies that have dependable cash flows. He has a sizable stake in AMC Entertainment. The company has low debt levels and is the second-largest theater company. He also likes Pathmark Stores, which does strong business in urban areas.

Durbiano, of Federated, says we will have continued modest economic growth and corporate earnings. He expects default rates will continue to decline. But the big risks are the impact of slow earnings on equity market valuations, falling consumer confidence and geopolitical uncertainty.

He favors the consumer and health care sectors. Holdings include Health Care Corp. of America and Premier Parks. Demand and cash flow are stable, unlike more cyclical companies.

One area where he's finding values is in the lodging sector. The hotel business still is feeling the effects of 9/11. But he favors Starwood, Host Marriott and Hilton because the companies have strong franchises and assets. He is underweighted in utilities, technology and telecommunications. However, he likes Qwest and U.S. West because the bonds have been beaten down.

"The real question is not if the U.S. economy and high-yield bonds will recover," he says, "but it is when they will recover."