Manager Margaret Patel thinks an economic recovery will help junk bonds.

Strong demand for junk bonds has some observers worried about an overheated market, and the prospect of higher interest rates is spooking many fixed-income investors. But Pioneer High Yield Fund manager Margaret Patel believes that upward momentum in the economy will help support further appreciation of high-yield bonds well into next year.

"Economic growth will accelerate over this year and next, which should contribute to positive performance in the high-yield market," says Patel. "Already, the U.S. economy has seen moderate growth despite relatively disappointing employment numbers." She adds that, historically, a presidential election year has been favorable for financial markets, including high-yield bonds.

Because they possess equity-like characteristics, high-yield bonds often perform well as the economy begins to gain steam, and this year has been no exception. Since the beginning of 2003, the average fund in the category is up 17.5%, according to Morningstar, while Pioneer High Yield has risen 22.3% over the same period. Much of that incremental return comes from the fund's hefty position in convertible bonds, which track moves in the underlying stock.

Just a little over a year ago, the picture for high-yield bonds was quite different, as investors flocked to the safety of Treasuries and government-backed securities in an uncertain economy. By the end of 2002, the Lehman Brothers Government Bond Index had risen 11.4%, while the Lehman's index of high-yield bonds fell 1.4%.

The loss would have been worse had it not been for the powerful rally in junk bonds that began in October. At the time, the yield spread between junk bonds and 10ten-year Treasury notes stood at a gaping 1,000 basis points, nearly twice its historical average.

But in the last two months of the year, a rebound that Patel had felt was long overdue finally arrived, as investors become increasingly confident that the economic recovery was not as fragile as some observers thought. At the same time investors, tiring of the low interest rates that higher-quality bonds offered, began turning to junk bonds for juicier yields. A short-lived summer stumble in high-yield bonds, prompted by rising interest rates and a supply-heavy market, quickly ended once rates stabilized, supply dwindled and demand perked up again.

Today's narrow yield spreads testify to just how strong that demand has become. At the beginning of this year, the yield of the Merrill Lynch High Yield Master II Index was 12%, compared with about 4% for ten-year Treasury notes. Today, rising prices have driven down the yield on the index to about 8.5%, while Treasury note yields have remained relatively stable. The powerful move has compressed the yield gap between junk bonds and Treasuries from 800 basis points at the beginning of the year to 456 basis points in early October. Going forward, Patel sees room for a "modest" amount of further narrowing as high-yield bond prices edge slightly higher, while Treasuries continue on a stable path.

Reflecting the strong demand for high-yield bonds by investors, assets of the Pioneer High Yield Fund rose from $3.7 billion at the beginning of the year to $7.1 billion at the end of September. New inflows from investors accounted for more than $3 billion of the increase.

An Overheated Market?

But the rebound could come to a screeching halt if the market becomes overheated, a concern some observers already have. One signal of frothiness is the yield compression between BB-rated bonds-which represent the most conservative end of the junk bond risk spectrum-and issues with more speculative ratings. With demand for high-yield bonds so strong, even dicey issuers have received a warm welcome from investors, including junk-bond fund managers eager to prop up yields and put heavy inflows of new money to work. Patel says the movement toward speculative credits "follows a typical rally at the end of a bear market, in which super-distressed issues that have experienced the most price erosion have the best move."

With demand for speculative credits so strong, investors today are not being paid all that well for taking a lot of risk, she says. In mid-September, only 9.62% of outstanding issues yielded 1,000 basis points more than Treasuries, the lowest level since 1998.