Good picks can be found and the market is stable, but tough times may be coming.

After several years of strong performance, it's questionable whether high-yield or junk bonds will earn their coupons this year. A confluence of factors are working against the high-yield bond market, such as narrow yield spreads in relation to U.S. Treasuries.

Moreover, a slowing of both the economy and corporate earnings are other culprits. The explosion in the number of leveraged buyouts is increasingly creating havoc in the corporate bond market because they are weakening bond covenants and companies' debt coverage ratios. The volatility of high-yield bonds has increased as a result of leveraged buyouts and mergers and acquisitions, according to recent reports. Plus, the high-profile private equity buyouts of Hospital Corporation of America and Freescale, a semiconductor company, resulted in some companies' outstanding bonds being called.

On the plus side, Fitch ratings reports that the default rate on domestic high-yield bonds hit a record low 0.8% in 2006. That's well below the long-term average of 5%. Meanwhile, Standard & Poor's expects that about 3% of high-yield bond issuers could default this year. But its research also suggests that default rates will rise. Typically, bond defaults rise and fall in five-year to seven-year cycles. The latest cycle of low default rates is in its fifth year.

Overall, the market is still on stable ground. Investors can pick up high-yield bond portfolios that are well-diversified across a wide range of industries, with yields about 3% more than U.S. Treasury bonds. In addition, the demand for high-yield bonds is strong. Pension funds, corporate bond funds and conservative investors are putting money into high-yield bonds to goose up their overall average investment yield.

Although there are some reasons for optimism, high-yield bond fund managers are cautious. James Keegan, manager of the American Century High Yield Fund, cites valuations as the reason. High-yield bonds had a tremendous run last year. The spreads on high-yield bonds are tight-in the range of 250 basis points above comparable Treasuries. Historically, they have been much higher.

Keegan says he's taking a defensive posture based on valuations and the credit cycle. He sold many of his CCC-rated bonds. The bulk of the portfolio is now invested in BB-rated and B-rated credits with stronger debt coverage ratios. He doesn't see default rates increasing dramatically, but a number of bonds issued three years ago could come under pressure.

Keegan also is avoiding many leveraged buy-out deals, except for some top borrowers in the high-yield sector, such as HCA Inc. The problem: In the past, junk bonds were issued to finance leveraged buyouts. But today, borrowers are tapping the collateralized loan market for lower rates. As a result, bank lenders have priority over high-yield bondholders if there is a default.

"Leveraged buyouts have accelerated dramatically over the past year," Keegan says. "Private equity firms have leveraged some credits to the highest levels. They have put so much leverage on cash flow that if there is a hiccup in the economy, there is not enough room for error. You have to be selective."

Keegan began increasing the fund's weightings in BB-rated and B-rated credits in the third quarter of last year. He primarily is sticking with companies that have strong credit profiles relative to similar issuers. The companies must have had stable cash flows and debt coverage ratios over the long term. He has significant weight in auto finance, particularly GMAC Credit, which was sold to a hedge fund. GMAC was one of General Motors' most profitable divisions. He also likes the gaming sector because of stable cash flows and high asset values. But he is underweight in home builders due to the decline in the real estate markets.

The fund's top ten holdings make up only 10% of the fund's assets. The fund's largest holdings include bonds from Idearc Inc., Lyondell Petro-Chemical, HCA and GMAC Global, Ford Motor Credit, Allied Waste and Asbury Auto Group.

Mark Vaselkiv, manager of the T. Rowe Price High Yield Fund, says many bond issuer fundamentals look good. Today, however, many companies' debt levels are too high.

"The fundamentals for the vast majority of our companies are very strong," Vaselkiv says. "One worrisome sign is an increase in behavior that is unfriendly to bondholders."

In the past, companies protected their balance sheets, reduced debt and enhanced creditworthiness. Today, companies are using cash to repurchase stock rather than pay down debt. Some are issuing debt to conduct leveraged or management buyouts. The buyouts lower companies' credit ratings and their bond prices subsequently decline.

"The aggressiveness of the LBO (leveraged buyout) sponsors will eventually sow the seeds for the next correction in the high-yield market," Vaselkiv predicts. "If there is a slowdown, we could see the default rate increase significantly."

Vaselkiv explains that although a 250 to 300 basis point spread in high-yield bond rates over U.S. Treasuries is low, the default rate on high-yield bonds historically is low. "The market has never traded below 300 basis points," he says. "But you have to remember we are experiencing the lowest default rate in the history of the asset class. The reality is that investors in the high-yield market are losing very little in terms of credit problems or defaults."

Vaselkiv says he's taken advantage of leveraged buyouts to pick up some debt issues by companies in strong businesses. About 20% of his fund's portfolios are invested in bonds issued for leveraged buyouts. For example, he owns HCA and Hertz Corp. Both companies have a lot of debt. But they are well-managed and their businesses are strong.

Longer term, however, he is concerned that the leveraged buyout bonds will get more speculative due to riskier deals that create more debt on the balance sheets.

He expects to invest in leveraged buyout deals in the newspaper industry. The Internet has hurt the newspaper business, but newspapers have predictable, steady and significant cash flow. "They make ideal candidates," he says." They can take that cash flow and apply it to paying down the debt.

He also likes the airline and auto industries. USAir's attempt to take over Delta is a positive sign. He believes General Motors and Ford will make a comeback. The companies still have a large market share.

"They're both (General Motors and Ford) CCC-rated companies today," he says. "I think the companies are making progress. They understand the challenges facing them. They have smart management teams and are taking decisive action."

He is also investing in some fallen angels-companies that in the past were downgraded to BB-rated and B-rated companies. For example, he owns Kodak and AT&T bonds. Kodak sold some assets and is going to retire some bonds. AT&T's business gained strength after being downgraded in the early 2000s. Telephone and wireless companies are more resilient. The fund's largest holdings include GMAC, Ford Motor Credit, Windstream, NRG Energy and Idearc.

Financial advisors who may be concerned about the impact leveraged buyouts will have on the high-yield bond market have a less-risky alternative. High-yield municipal bonds are paying 5.5% or more tax-free. That translates into taxable equivalent yields of 7.5% for high-tax-bracket investors. The taxable equivalent yields are on par with taxable high-yield corporate bonds.

High-yield municipal bonds typically are issued to finance economic or industrial development, environmental projects and health and retirement care facilities. John Cummings, manager of the PIMCO High Yield Municipal Bond Fund, expects steady returns on high-yield, tax-free bonds. Default rates have averaged less than 2% over the past 30 years, and the recovery rates are high. Plus, investors don't have to worry about leveraged recapitalizations and the drain dividend payments to stockholders have on corporate cash.

Cummings says about 55% of high-yield municipal bonds are unrated. Those that are rated typically carry B ratings by Standard & Poor's. Nevertheless, the market for these bonds is much deeper than in the past. Issuers are financially stronger.

In addition, these bonds have just a 15% correlation to the S&P 500. By contrast, high-yield corporate bonds have a 50% correlation to stocks. The reason: high-yield munis finance projects with less cyclical revenue streams and with hard assets as collateral. Corporate high-yield debt, on the other hand, finances the growth of companies and equity prices are dependant on that growth coming to fruition, he says.

"The demand is strong and issuer default rates are low," Cummings says. "Where there are defaults, the recovery rates are high. You can pick up 100 basis points and not increase your default risk by investing in high-yielding municipal bonds."

Cummings owns about 100 different bonds and no one issuer makes up much more than 1% of his portfolio. In selecting bonds, he looks for issuers that are economically viable. The issuers must have strong cash flow and debt coverage ratios compared with their peers. The issuers should have a strong franchise for their services. Many bond issues are tied to revenues, such as the Newport Beach, Calif., toll road, or local hospitals. Hospital revenue bonds, special tax bonds, industrial development bonds, educational revenue bonds, state and local general obligation bonds and housing bonds are the majority of his portfolio.

The biggest risk in the high-yield muni bonds, Cummings says, would be a change in the federal income tax rate. Lower rates make tax-free bonds less attractive. Natural disasters, such as hurricanes, earthquakes and tornadoes could send bond prices tumbling. Plus, his portfolio sports a duration of eight years. So a 1% rise in interest rates would result in about an 8% decline in the price of the bonds held by the fund.