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.

The question now is whether high-yield bonds are sweetening the yield pot enough to continue to attract investors. Patel thinks that's still the case. "In my mind, today's narrow yield spreads are justified by lower credit risk and an improved economy," she says.

Patel counters concerns of an overheated market with the observation that default rates have decreased dramatically, from a peak of 11% in January 2002, to just below 6% in August of this year. It is also a more diverse marketplace, she adds, with many of the now -defunct, highly speculative media and telecommunications companies that once populated the junk bond market replaced by new issuers representing a variety of industries.

Although she believes default rates should trend "modestly lower" over the next year, a pickup in defaults among issuers in the lower credit tiers could reverse that trend further out. To head off that possibility, she prefers to stick with BB and B names, which represent the better-quality end of the junk bond spectrum. These bonds currently yield 300 to 500 basis points more than Treasuries, compared with yield spreads of 600 basis points or more for lower-quality issues. The possibility of an increase in defaults among lower-quality issuers, she says, justifies what she considers a modest sacrifice in yield.

Convertible Kicker

Pioneer High Yield Fund has traditionally maintained a heavy presence in convertible bonds, which now account for 55% of fund assets. Patel had two-thirds of the fund in convertibles at the beginning of the year, but pared back when they began trading above par, or when the issuer called them. She has put much of that money into some straight high-yield bonds that she believes have more favorable valuations than convertibles right now.

The fund's hefty allocation toward convertibles makes it something of an anomaly among garden-variety junk bond funds that focus mainly on traditional high-yield debt. "While many of the fund's peers dabble in convertible securities, this fund feasts on them," notes Morningstar analyst Scott Berry. "That exposure can cause the fund's short-term returns to diverge dramatically from that of the high-yield category as a whole, and can add to the fund's overall volatility."

Over the long-term, however, the convertible bond position has contributed to the fund's excellent performance, Berry adds. Its performance ranked among the top 3% of high-yield funds in 1999, 2000 and 2001, although it underperformed the group slightly in 2002 when the stock market downturn hit hardest. Over the past year, the fund is up 39.7%, putting it in the top 7% of funds in its Morningstar category over the period.

Patel views convertible bonds as a way to obtain industry exposure beyond what the high-yield bond market offers, because many smaller, rapidly growing technology and health-care companies prefer to issue them over straight high-yield debt. Their equity kicker also serves as a possible source of capital appreciation, particularly if narrowing yield spreads put a damper on the growth potential for straight high-yield bonds.

Patel prefers to buy convertibles that trade at a steep discount and have wide conversion premiums. Because the odds of the bonds being converted to stock are initially low, they trade on bond value and have a more muted response to changes in stock price than bonds with narrower conversion premiums. At the same time, these discounted convertibles respond more closely to changes in the underlying equity than traditional high-yield bonds, yet offer similar yield characteristics. Once the bonds begin to trade above par value, Patel will begin moving out of the position.

A large presence in the technology sector, which represents 30% of assets, has contributed to the fund's strong performance so far this year. At 22% of assets, healthcare represents the second largest sector allocation. Ivax Pharmaceuticals, a recent purchase in that sector, produces generic drugs that should benefit from the increasing use of those products. In the technology area, Patel likes Sanmina Corp., a component and semiconductor manufacturer.

Balancing out the fund's volatile technology and health care holdings is a substantial allocation toward economically sensitive industries such as basic materials and industrial manufacturing. Those areas would be likely beneficiaries if Patel's vision of a sustained economic recovery indeed takes hold.