Manager Tim Rabe thinks junk bonds will return about 5% in 2005.

    Tim Rabe, manager of the Delaware High-Yield Opportunities Fund, believes that this year, with concerns about rising interest rates widespread and yield spreads so tight, high-yield bond returns won't measure up to the appetizing levels investors saw in 2003 and 2004. "There is not a lot of room for capital appreciation, and most returns in 2005 will come from income," he cautions. "I anticipate that the high-yield market will deliver returns in the 5% to 6% range this year."
    Despite that warning, he believes that improving balance sheets and the underpinning of solid economic growth have kept the high-yield market in "pretty decent" shape for now, and that high-yield bonds present a worthwhile alternative to other investments. "Even though below-investment-grade bond yields aren't that attractive on a historic basis, I believe they are still a good alternative to the high multiples of the equity markets and low Treasury yields," he says. "A 7.5% coupon looks awfully good compared to what's out there. I think high-yield bonds will outperform investment-grade credits in 2005."
    At this point, the race to the year-end finish line is a tight one. At the beginning of August, high-yield bond funds had a year-to-date total return of 1.93%, compared with 2.37% for long government bond funds, according to Morningstar. Over the last year, the two types of funds have returned 9.61% and 8.10%, respectively.
    This year's muted performance for the sector beats the troubled economic climate of 2001 and 2002, when issuers had trouble paying their coupons, default rates rose and the high-yield market sank. The economic recovery in 2003 and 2004 helped junk bonds bounce back, with high-yield funds delivering returns of 24% and 9.8%, respectively, for those years. The rally left junk bond yields closer to Treasury bond yields than they had been in a long time. Early in the year, the spread between the Merrill Lynch High Yield Master II Index over comparable Treasuries stood at around three percentage points, well below historical norms and much narrower than the yawning gap of roughly ten percentage points in 2002.
    Despite some market setbacks this year, junk bonds managed to bounce back and yield spreads remained tight through the summer. At the beginning of August, when the ten-year Treasury yield was 4.28%, the Merrill Lynch Corporate Master Index of investment grade bonds was yielding 5.12%, while the Merrill Lynch High Yield Master II Index yield was 7.45%.
    Low default rates, which fell from a high of 10.9% in January 2002 to a little over 2% today, have aided the high-yield market. Default rates for speculative-grade credits could rise by the end of the year but should remain modest from a historical perspective, predicts Standard & Poor's. The rating agency's credit upgrades to investment-grade status in 2005 numbered 34 through July 18, compared with 23 downgrades to a below-investment-grade rating during the same period.
    The market also has rebounded from the May credit downgrade of General Motors' low-investment-grade status to double B, the highest speculative grade. In late March and early April, high-yield bond investors suffered the double whammy of a spike in interest rates and concerns that an influx of downgraded GM paper would flood the market and drive prices down.
    Neither event materialized. Although short-term interest rates went up, long-term rates remained stable. And investors managed to digest the 7% increase in the dollar amount of debt that GM added to the high-yield market. In the three months ended July 31, high-yield funds rallied to return an average of 4.77%, according to Morningstar.
    But the prospect of rising rates presents more of a threat to junk bond prices than it has in the past. Usually, high-yield bonds are much less sensitive to interest rate movements and more sensitive to the stock market than are investment-grade securities. With the yield spread to Treasuries so tight, however, high-yield bonds have started to respond more like their more upscale brethren to interest rate fluctuation. "As long as yield spreads are tight, prices of high-yield bonds will be more sensitive to moves in the Treasury market than they otherwise would be," notes Rabe.
    In a worst-case scenario, he says, a flight to safety could spark a high-yield sell-off even as Treasury securities rally. At the same time, the erosion of the yield cushion could make high-yield bonds more susceptible to a downturn in the equity markets than they have been in the past. Despite those risks, Rabe thinks high-yield bonds have an advantage over stocks because their returns are not as dependent on earnings growth. "The high-yield market doesn't need the world to grow," he says, "It just needs to generate enough cash to pay the interest on its debt."
    Another concern to investors is the potential for default rates to rise this year, particularly if the economy slows down. Credit downgrades exceeded upgrades in the second quarter, according to S&P. And while there have been 50% more "rising stars" this year than during the same time frame in 2004, the number of "fallen angels" increased as well.
    Rabe acknowledges an increase in the number of issuers at the lower quality end of the junk bond spectrum over the last year, but maintains, "This is not a return to the speculative years of 1998 through 2000, when most triple C issuers were emerging telecoms with no cash. Many lower-rated companies today are highly leveraged but have positive cash flow characteristics as well. Their rating reflects how private equity companies driving leveraged buyouts are choosing to capitalize."
    Perhaps the biggest factor tipping the scales in favor of high-yield bonds is the fundamental strength of the underlying issuers, Rabe says. "There are very few companies out there missing their earnings targets or credit metrics," he says. "Out of 140 to 150 names we have in our portfolio, only two have not exceeded earnings expectations." 
    The fact that companies with speculative ratings have managed to hold their own in a difficult environment testifies to their resiliency, he adds. "The high-yield market has managed to weather difficult operating environments, high oil prices and volatile commodities markets this year," he says. "The prospects for these companies should remain stable or improve." At the same time, the "global reach for yield," as well as increased participation in the high-yield market by pension funds and other institutional investors seeking to shore up portfolio yields, will continue to support demand.
    Rabe, who has managed the fund since 2002, has been tailoring the fund's investment strategy to mitigate the impact of a rise in interest rates and avoid companies that could be vulnerable to a business slowdown. "In this environment the key is avoiding pockets of disruption," he believes.
    To identify potential trouble spots as well as opportunities, Rabe analyzes macroeconomic factors to identify undervalued industries with expected strong short-term performance. He also tries to forecast key top-line drivers such as free cash flow, interest rate coverage and debt coverage.
    With the uncertain outlook for auto sales, he cites auto parts suppliers as a possible problem area for the high-yield market. On the other hand, paper manufacturers like fund holding Abitibi Consolidated stand to benefit from capacity shutdowns by larger companies that have helped bring supply into line with demand. Rabe bought the company's bonds about two years ago after they sank to "fallen angel" status following a rating downgrade.
    At 3.8 years, the portfolio's average effective duration is on the shorter side for the fund, reflecting Rabe's concern about rising interest rates. He uses yield-to-call bonds, which are likely to be refinanced by the issuer within three to 18 months, to shorten duration and limit interest rate risk. Many of these bonds were issued several years ago with five-year call protection, at a time when yields were higher than they are today. Now that the call date is approaching, the issuer is in a position to redeem or repurchase the bonds early at lower rates. In the meantime, these high-coupon securities have volatility characteristics similar to shorter-term paper. Rabe says he also attempts to control interest rate risk by overweighting the fund in single B names, which are less tied to the fluctuations of the Treasury market than issues at the higher-quality end of the junk bond spectrum.