With default rates near historic highs, the threat of rising interest rates, a sticky recession and a stagnant stock market, it would not be too difficult to argue convincingly against investing in high-yield bonds. Yet they could be an attractive alternative for those willing to bet on an economic recovery because, historically, high yield bonds have made their strongest showing when the economy is turning the corner. Their returns can rival even those of stocks, as they did in 1995, when the average junk-bond mutual fund had a total return of 17.7%.

But even optimists should rein in their expectations this time around, says Bruce Monrad, co-manager with his father, Ernest, of Northeast Investors Trust, the venerable, 52-year-old high-yield bond fund. While the younger Monrad believes high-yield bonds will offer attractive returns relative to stocks or to other types of debt over the next several years, he warns investors not to expect a replay of the junk joy ride that followed the economic recovery of the early to mid-1990s, when tumbling interest rates gave the bonds a boost.

"Things are not going to be quite as rosy for high-yield bonds as they were coming out of the 1991 recession," he says. "The Fed isn't going to lower rates much further, so that tail wind is gone. If high-yield bonds earn their coupon over the next three years, and maybe a little something on top, I'd be happy."

So would lots of other investors stuck between low bond yields and even lower stock market returns. The question of whether or not junk bonds have performed well recently, and whether they'll deliver appealing returns going forward, depends on what you compare them to. With their hybrid investment profile, many financial advisors view junk bonds as an equity alternative, rather than a dyed-in-the-wool member of the fixed-income group. Changes in interest rates often don't affect junk as much as other types of bonds, since investors focus more on their credit characteristics. Yet they also respond favorably to equity market upturns and economic recovery.

Last year, the junk-bond fund group rose an average of 1%-well below the 6.5% gain for the average general corporate bond fund, but a lot more palatable than the 11.8% decline for the S&P 500 Index. The comparative pattern seems to be repeating in 2002. As of mid-September, the average junk fund was down 5.3%, compared with a gain of 5.4% for the average general corporate bond fund and a stinging 22% loss for the S&P 500 Index.

Northeast Investors Trust nosed out the average junk fund in 2000 with a 6% drop, about 1% better than its peers. In 2001, its 1.3% return beat its average peer by a 0.2% sliver. So far this year, the fund is up 2.7%-helped, no doubt, by its miniscule expense ratio of just 0.21%, about one-eighth the average for high-yield bond funds.

But it is its long-term track record that has given Northeast Investors Trust a reputation as one of the industry's most respected junk bond funds. Its average annual return of 7.67% over the 10 years ending August 31 puts it in the top 1% of its category, according to Morningstar.

But its solid long-term track record, however, wasn't enough to keep investors from heading for the exit door three years ago. Today, the fund has assets of $1.5 billion-around what it had in 1996-compared with a peak of $2.3 billion in 1998.

Monrad acknowledges that at least some of the asset bleed happened when the fund sidestepped telecommunications company bonds in the late 1990s, just as many other junk-bond funds were frantically scooping them up. As the bonds flooded the market, he wondered how these high-debt, low cash-flow businesses would be able to survive, let alone pay their coupons. While avoiding the telecom market hurt the fund's comparative performance in 1999, when the sector's popularity soared, the strategy worked in his favor when the telecom meltdown began in 2000.

Why Junk Now?

Over the last few years, the yield spread between high-yield bonds and Treasuries with similar maturities has ranged from 2.5% in 1997 to 10% in the fall of 2001. Currently, the yield gap is 9%, and Monrad believes that the generous coupons the bonds carry add to their appeal. According to Moody's Investors Service, junk bond yields averaged 12.7% at the beginning of September, some 8.9% higher than the 10-year Treasury note.

But with those high coupons come the high rate of defaults that continue to plague the market. Monrad expects default rate for 2002 to come out at around 10%, a high level similar to last year's and well above the historic average of about 3%. "Defaults should start to subside in 2003," he says. "The telecom company wipeouts will be behind us, and the companies that survive through this year will have proven their staying power."

Other possible roadblocks for the junk-bond market include the risk of a "double dip" recession, which would exacerbate problems that shakier credits are already having. The stock market would need to firm up to give junks the lift they've gotten from rising equity values in the past. But if interest rates rise too quickly, yields on rate-sensitive Treasury securities could jump more rapidly than less sensitive high-yield bonds. That would close the yield gap that now adds to junk's appeal.

Yet some analysts share Monrad's view that despite these problems, the high-yield bond market could hold some pleasant surprises. "There is value in many sectors of the high-yield bond market, though not all sectors, and we believe this value will be captured as the economy recovers," notes the August 2002 issue of the No-Load Fund Analyst, an investment newsletter published by Litman/Gregory Research in Orinda, Calif. "In the meantime, there will be default losses, but these will be partially offset by very high interest yields. High-yield bonds won't do well in a deflationary environment, but stocks would very likely do even worse" The firm recommends a 14% allocation to junk bonds for its balanced portfolio, and includes Northeast Investors as one of the two high-yield bond funds it uses for clients.

No "Fallen Angels"

Monrad's upbeat view of the junk bond market does not extend to former investment-grade bonds from companies such as Tyco International, WorldCom, and Qwest Communications, whose debt has been downgraded because of financial difficulties-the so-called "fallen angels" that some junk-fund managers are scooping up. Monrad remains wary of the bonds.

"I have to admit I've been dragging my feet on buying fallen angels," he says. "They are complex compared to a typical high-yield bond. And because they used to be investment-grade issues, they don't have as many protective covenants. It's also hard to get a handle on what's going on inside these companies."

Instead, Monrad turns to issuers with cash flow that he considers strong enough to meet coupon payments and a substantive level of real assets. While many funds balance lower-rated bonds with a healthy dose of BB- rated credits-the highest quality available in the speculative bond category- Monrad often fishes in the lower end of the credit rating pool. Only 5% of the fund, in fact, is invested in bonds rated BB or higher. About one-quarter of assets are in bonds rated CCC or lower.

"I've had some sticker shock with BB bonds," he says. "Their yields are in the 6.5% to 7% range, which is way too close to Treasuries. They also have a higher level of interest rate risk than lower-rated bonds."

Holdings that fall into the lower-rated category include CCC-rated AMC Entertainment, the second largest movie theater chain in the country. Although the industry has been squeezed by overbuilding that started in the mid-1990s, Monrad thinks AMC has a stronger financial footing than competitor General Cinema, which has filed for bankruptcy. The 9.5% coupon bonds have a current yield of 11%. Monrad thinks the bonds are underrated and have the potential to rise in value if rating agencies bestow an upgrade.

The gaming industry's steady cash flow helped attract Monrad to the fund's largest holding, Trump Atlantic City's 11.25% coupon first-mortgage bonds. He began buying the bonds in 1998 as an alternative to what he considered riskier telecom issues and has added to his position over the years. They currently yield 14%.