September was the cruelest month for junk bonds, snaring investors and some advisors in a trap. Many of them had invested in the high-yield sector late in the 1990s, based on big yields that dwarfed the modest payouts of Treasuries. This disparity led them to think that junk was an investment with better risk-adjusted numbers than the bubbly stock market. Back in the halcyon late 1990s, high yields then were routinely returning 10% to 15% a year. But September was only the worst of what turned out to be a terrible three-year period for junk bond funds.

"To say high-yield bond funds have suffered in recent years would be an understatement," says Scott Berry, a Morningstar analyst. "While tumbling tech stocks, a weak economy and the terrorist attacks of September 11 have hit stock funds hard, high-yield bonds have fared worse over the past three years."

Consider this: Before the calamitous events of September, the annualized return on the average high-yield bond fund was virtually zilch for a three-year period through the end of August at -0.02%. Those numbers even placed these funds behind the communications and technology funds categories, according to Morningstar. High-yield performance

wasn't much better through the end of October. Its three-year number then was -0.73%. And its five-year number was only 1.21% compared with the S&P 500's 9.72% in the same period, according to Lipper.

But the trap was laid again earlier this year for credulous investors. In January, with the stock market wobbling, junk bond funds jumped 6% in that month alone.

Junk seemed poised for a turnaround. Even though many observers expected junk bond default rates to rise, investors thought the yields provided adequate compensation for the additional risk, making the vehicle a safe place to seek shelter from a bear market in equities.

But it proved to be an illusion. Junk's problems were just beginning again and would climax in the fall. In just one month, the average junk bond fund was down 5.92%, according to Merrill Lynch's high-yield bond index. For the year, through the end of October, the average high-yield fund was down 1.25%.

Telecom players, such as Iridium and Winstar Communications, went bankrupt in the last few years, and others followed. September became one of the worst months for junk bonds in 15 years. The only other two worse months for junk were those when Michael Milken's firm, Drexel Burnham Lambert, went under during the last recession a decade ago. Even the average annualized five-year high-yield fund number wasn't good-up 0.9%, according to Lipper. "It is not an attractive time for investors in these funds. This is a tough time. Advisors should be looking at these things as a long-term play," said Jeff Molitor, a principal and director of portfolio review for the Vanguard Group.

Not so, says Kingman Penniman, president of an investment-advisory firm in Montpelier, Vt. "The spread between high-yield bonds and Treasuries now represents a great opportunity for investors, provided they're careful," says Penniman, of KDP Investment Advisors. He says if there are more terrorist acts or if the war in Afghanistan drags on longer than expected, then the junk bond market will be hurt, especially aggressive funds heavily exposed to lower-grade bond issuers that have lost the most over the past year.

Vanguard's conservative High Yield Corporate Bond Fund is an example of a fund that has not been badly hurt. It is down only 0.8% for the year through September, and it is up 1.1% for the three-year period. Those numbers are outstanding compared with others in the category, but Vanguard's junk vehicle doesn't sport the juicy yield many rival funds boast. Molitor says many junk bond funds are doing poorly because they're overweighted with tech, telecom and other bonds with lower than BB-plus ratings. But when the junk bond market finally turns the corner, Vanguard's conservatism may cause its fund to lag.

In the short term, junk bond funds will continue to face problems, analysts agree, since the post-September 11 economic slowdown inevitably will trigger more defaults. "Defaults have not peaked. They are not expected to do so until the economy starts to turn around in the second quarter of next year," says Diane Vazza, head of Global Fixed Income Research for Standard & Poor's.

For those who do venture into junk and pick the right offerings, the potential returns after an extended bear market are considerable. In September, the average junk bond yield, fueled by declining trading prices and a rising number of defaults, rose to 13.95%. That added up to a difference of 9.77% compared with Treasuries. The previous month, the spread was 7.84%, according to a Merrill Lynch index.

Nevertheless, advisors should be looking for funds that have selective portfolios, many experts says. That means avoiding funds that were and still are overweighted in telecommunications and tech bonds. These are the ones that could not avoid recent disasters.

As of early October, 121 rated global bond issuers have defaulted on $74.3 billion. That's versus 108 issuers defaulting on $34.3 billion of debt in all of last year, according to Standard & Poor's. In the third quarter, 23% of the defaults were in the telecommunications sector, followed by 13% in capital goods. Exodus Communications, a U.S. telecommunications firm, had the biggest default. It couldn't service its $6 billion in debt.

And for the year, telecommunications has the dubious honor of leading in sector-default rates. It accounts for 19% of the defaults and 41% of the volume, according to S&P. Those defaults have translated into many problems for funds. The more aggressive junk bond funds couldn't load up fast enough on the high-yielding telecommunications bonds in 1997, 1998 and 1999. Some examples are funds such as Morgan Stanley High Yield Securities and PaineWebber High Yield. Morgan Stanley, which just changed leadership in January-after an egregious 2000 in which it lost 30.61%-previously had more than a quarter of its portfolio in bonds rated below single B.

"Both funds," says Morningstar's Berry, "place an emphasis on yield, which led them to the telecom sector like moths to a flame." The Morgan Stanley fund lost 42% over the 12 months ended October 31, and the PaineWebber entry was down some 20% in the same period.

"We underwrote a lot of bad credit in 1997 and 1998," concedes Raymond Kennedy, a portfolio manager and a member of PIMCO's investment strategy group. Still, PIMCO's High Yield Institutional Fund has been able to work through the problems. Over the last year, it has lightened up on telecom and cyclicals and moved into basic industries such as autos and steels.

Its leading position recently was Fannie Maes. Therefore, it is only down 0.75% for a one-year period through September 30. And it is actually up 2.34% for the terrible three-year period for junk and ahead 5.39% for the five-year period. Its one-year, three-year and five-year annualized numbers through the end of October also are good: a positive 3.59%, 3.44% and 5.65%, respectively.

Those are glowing numbers for this beaten-up category. But although the junk bond fund category has terrible numbers, there are some funds that have been able to avoid the late-1990s telecommunications trap. Top performers of the last three years include Pioneer High Yield-funds that always have had a relatively low share of techs and telecommunications and higher-quality bonds in general. Pioneer was ahead by 9.03% for the year through October and up a whopping 18.58% for the three-year period.

Pioneer's magic formula includes going easy on the techs and tapping into convertibles and energy. However, these outsized returns have come with considerable risk. "Like traditional high-yield bonds, the fund's convertible issues carry substantial credit risk," says Morningstar's Berry. "In addition, the fund's large convertibles stake could cause it to lag its average high-yield peer if the high-yield market rallies and the stock market doesn't."

The market has been signaling doubt about the junk market. The junk bond spread-the difference between the yield on these high-risk bonds and the haven of Treasuries-recently has been averaging between 9% and 10%, according to the Lehman Brothers Bond Index. This means that junk bond funds either represent one of the few opportunities to obtain decent returns in a bear market or are another trap for those who believe any kind of fixed-income investment can generate strong numbers in a bear market.

"I think the spread represents the greatest opportunity for junk bond funds since the problems of the early 1990s," says Theresa Fennell, a portfolio manager with American Century. Nevertheless, the last three years have been rough for the American Century High Yield Fund. It was down in the third quarter by 7%; for the year, it was minus 2.5%; and for a one-year period through October 31, it lost 3.6%. Through the last three years, it lost 1.4%.

Still, Fennell is optimistic about the long-term prospects for junk. Fennell's reasoning: There's no Drexel Burnham Lambert crisis to drag down the market, and she projects that default rates are at or close to their peak. "The technicals are in better shape than in 1990-91," she says.

Spreads represent a great opportunity for yield-hungry investors who are expecting the stock market to continue to disappoint, she adds. "The fundamentals are going to continue to go down in the short term," adds Michael Weilheimer, director of the high-yield department for Eaton Vance and manager of its High Income-B fund. "Third-quarter earnings were impacted and so will fourth-quarter earnings."

But by tightening the portfolio and easing up on dicey sectors, such as automobiles and techs, he hopes his fund will have strong performance over the next year. Weilheimer's fund has some catching up to do. For the three-year period, it has returned a negative 1%. Like many observers, Weilheimer still believes high yields now "are at a very attractive stage."

But the question now is how low is low. Vanguard's Molitor says the focus on spreads is why this category has had massive problems and why the problems will likely repeat as too many investors throw too much money into funds that provide loans to questionable companies. "Advisors should not compare these investments to Treasuries. That is the wrong way of looking at these volatile investments," Molitor warns.

Fennell's strategy is to tighten a bit on bond quality and duration: Don't go any lower than double B-rated bonds and don't go out any farther than four years. In the short term, she says, there may be a few more problems, but in six to nine months, she expects a strong rally in the junk bond market. "Stick to the higher quality, and you will do just fine," she says.

Sound good? Many recall that junk bonds were the top-performing asset class in the early to mid-1990s after the economy emerged from a recession. The flip side of this rosy scenario is the late 1990s. "Of note is that 76% of the defaults this year were bonds issued in the 1997-1999 period. In those three years alone, $373 billion of high-yield debt was issued," declares a recent report by Standard & Poor's. Just as leveraged buyouts provided a Waterloo for junk bonds in the late 1980s, tech and telecom filled that role in this cycle.

The corporate-bond default rate has been rising since 1997, according to the report. It is expected to rise to 10% by the end of 2001, the report projects. And another cautionary note comes from Molitor, who says junk bonds don't perform like traditional ones and have a greater correlation with stocks than with bonds.

"The yield in high-yield funds is very distorted right now. A lot of these funds with big yields are doing so with distressed assets. How long is that going to last?" PIMCO's Kennedy asks. If the 1990-91 experience proves to be a distant but accurate mirror, a number of bonds selling at 60 cents on the dollar may ultimately get converted into equity in a restructured business at 10 cents on the dollar.

For yield-hungry clients who need a major source of income, junk is one of the few alternatives remaining in a bear market. However, there is junk-a conservative approach emphasizing better quality and lower duration issues-and then there is trash. The latter means loading up on the highest-paying, yet riskiest entries, an approach that has imploded, not only over the past few months, but also over the past three years, analysts note. Also, advisors must prepare clients for volatility in junk bonds, similar to what they would expect with garden-variety equities.