Concern about the economy adds
a note of caution to a hot category.

    Financial advisors doing year-end portfolio tuning should give the high-yield portion of fixed-income investments a little extra scrutiny, and keep a close eye on their positions in 2007.
    A downturn reminiscent of the fiasco that occurred between 2000 and 2002, when the dicey credits that were financed in the late 1990s turned sour and defaults skyrocketed, appears highly unlikely. Most companies, including those rated below investment grade, typically have better balance sheets and brighter prospects for solvency these days. But warning flags, including the potential for a slower economy, higher default rates and lower recoveries, are prompting some prominent fixed-income analysts and portfolio managers to stress a cautious approach to the market over the next year or two.
    "There is always a reason to have a strategic allocation to this asset class," says Ray Kennedy, managing director at PIMCO who heads the firm's global high-yield bond team. "But this is a good time to be leaning toward the lower end of a tactical allocation range."
    This prudence comes at a time when the performance of high-yield corporate bond funds has beaten just about every other U.S. fixed-income category over the last few years. Through mid-October, the group averaged annualized returns of about 8% and 9% over trailing three- and five-year periods, respectively, compared to around 5% and 6% for the average long-term diversified bond fund, according to Morningstar. The story has been a similar one in the high-yield municipal bond market, where demand for lower-quality paper has boosted prices and compressed yield spreads among different quality issuers.
    Despite warnings of an economic pullback that would hurt lower-tier credits, this year has proven to be rewarding for the group as well. Through mid-October, high-yield bond funds were up 6.6% for 2006, compared with 1.88% for the average long-term bond fund. Default rates, a critical driver of high-yield bond prices, remain low. Corporate profits are strong, the economy looks headed for a soft landing rather than a hard thump and interest rates have leveled off.
    Yet the storm clouds gathering over the high-yield market are hard to ignore. In a recent report Diane Vazza, managing director at Standard & Poor's, warns that a "more cautionary stance for high-yield investors at this stage of the credit cycle is important." The growth slowdown underway is "likely to dent profits growth and trip credit quality in the process," while defaults, though they remain low, could rise because they typically follow rather than lead turning points in the credit cycle.
    Other credit quality indicators are already showing signs of stress. Downgrades have been exceeding upgrades by a significant margin, and a sizable 31% of high-yield firms have ratings on negative CreditWatch or outlook. The firm expects the speculative default rate to climb past 3% in 2007, compared with less than 2% so far this year. Kennedy believes that default rates next year should max out at between 2% and 3%, but could increase to more historic norms of between 3% and 5% after that.   
    While high-yield bonds participated in the third quarter bond rally they failed to beat other fixed-income investments, despite a strong stock market that should have given them a more forceful tailwind. "While high-yield bond returns for the third quarter looked impressive at 3.9%, the returns on high-grade bonds were higher at 4.7%, while the ten-year Treasury fetched 4.6%," notes Vazza.
    Tight yield spreads are also making investors weigh the risk-reward tradeoff in high-yield bonds more carefully. Over the last ten years, the yield on the Merrill Lynch High Yield Master II Index has averaged about 500 basis points over Treasuries. Spreads were down to around 300 basis points earlier this year, and had widened to a still-skinny 350 basis points by the fall.

Spreads could remain below average well into 2007. "It's highly unlikely that we'll see 500 basis point spreads next year," says Kennedy, "But it could certainly happen over the next three years. This is a classic credit cycle and there is nothing mysterious about it."
    Kennedy says the increasing use of leverage at some companies will almost certainly put pressure on the high-yield bond market in the future. Private equity firms on the leveraged buyout trail have added billions of dollars of debt to the balance sheets of below-investment-grade companies they set their sights on. In some cases, companies are aggressively buying back stock with borrowed funds, and the increasing use of bank debt adds another layer of lenders demanding timely payback. With so much senior debt outstanding, recovery rates on unsecured debt will probably fall.
    Other, less risky investments are also taking away some of high yield's thunder. Cash investments are yielding 5% or more, making the 7% to 8% yields on high-yield bonds less attractive by comparison. Bank loan funds have become an increasingly popular choice for investors over the last few years, and the debt they invest in is senior to high-yield bonds.
    Still, the surprising resilience of the group, and of the economy in general, has left some money managers convinced that any significant problems are at least a year away. "We've had 17 consecutive quarters of double-digit profit growth, and that bodes well for the lower-quality market," says Jim Kauffmann, head of fixed-income investing at ING Investment Management. "Unless the Fed raises rates or we get an inflation scare, it looks like clear sailing."
    Kauffmann points out that returns on bonds rated CCC or lower have outpaced the returns on bonds at the more conservative end of the junk spectrum by a wide margin this year, and that funds willing to move down the credit spectrum have performed better than those with more conservative leanings. "It usually takes about three to four years for a very-low-quality borrower to default, so we're still a year or two away from the point where people may want to get more conservative," he says.
    Mark Durbiano, who manages the $1.3 billion Federated High Income Bond Fund, agrees that rising default rates do not appear to be a major threat at this point in the credit cycle. "We started the year talking about par value default rates going up to 2% or 3%, but we'll be hard-pressed to see it hit 1% this year," he says. "They could tick up in 2007, but we're talking about coming off some very low levels by historic measures."
    With concerns about certain sectors such as housing and automobiles on the economy, Durbiano thinks spreads could widen early in 2007 to as much as 450 basis points, but will probably narrow as the year progresses. "In the meantime, while all that is happening, you're collecting a big coupon," he says. To accommodate a variety of economic scenarios, Durbiano is using a barbell approach by investing in higher-quality paper to protect against widening spreads, while at the same time keeping a foot in lower-quality bonds "that can run for us if credit fundamentals for specific issuers picks up."
    Kennedy is focusing his investments on more seasoned issuers in the utility, finance and banking industries that have valuable assets and tend to have higher overall recovery rates in the event of default. He's also been adding bank debt, which allows him to move senior in the capital structure and provides some insulation from risk. With the yield curve as flat as it is now, he's getting a high current yield as well.
    "Credit selection is always important, but there are times when you can buy a marginal credit and still do well," he says. "This is probably not that time."