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Is there still money to be made in the high yield market?

It all depends upon your expectations.

Clearly, the big money has already been made. So, if you aren?t in this market already, you missed out on some great gains.

Last year, the high yield market racked up a total return of 27.23 percent, including 16.5 percent from price appreciation and about 10.7 percent from income, according to Merrill Lynch.

And the asset class climbed another 9.26 percent in the first quarter of this year, thanks mostly to the hefty coupons.

However, many investors are cashing in their chips.

A number of hedge funds that made big bucks in this asset class have already taken profits and moved on to the next big opportunities.

According to AMG Data Services, mutual fund investors pulled out money from junk bond portfolios in each of the three weeks following the train bombings in Madrid. Altogether, fund investors have yanked out $1.6 billion from junk bond funds this year.

At the same time, the market has been flooded with new issues, amounting to $18 billion, according to Citigroup Global Markets. As a result, Citigroup concedes it has become ?more cautious, mainly due to large issuance and continuing mutual fund outflows.?

"On a total return basis, the market looks fully valued," Roger Gordon, head of high-yield bond research at Banc One Capital Markets, recently told Reuters.

One reason: Spreads?the yield compared to comparable Treasurys?have narrowed to a mere 387 basis points, which is near the recent low of 374 points, according to M. Christopher Garman, high yield strategist at Merrill Lynch.

?The 1 percent level of Fed funds is having a gravitational pull on all spread products,? notes William C. Powers, Managing Director and Senior Member of PIMCO?s Portfolio Management and Investment Strategy Groups, in a recent report. ?We think this is a target-poor environment for investors looking at high yield product.?

Meanwhile, the trend for interest rates is to go higher, especially if you believe the economy will continue to improve.

In addition, Standard & Poor?s recently warned in a report that although the global corporate speculative-grade bond default rate fell in March to 3.87 percent, which is well below the long-term average of 5.27 percent, the default rate could rebound over the next few years.

"In the U.S.--and to a lesser extent, in Europe--a trend displaying a rising proportion of lower grade issuance in 2003 serves as an early warning of renewed default pressure two to three years ahead," said Diane Vazza, head of S&P's fixed income research group.

Even so, Merrill?s Garman says if you insist upon devoting some of your money to the fixed-income market, high yield bonds are a much better place to investment than Treasurys.

?It?s a good match for investors who don?t like equities or bonds,? he explains. ?It?s always a good intermediate step between interest rate risk and equity-like risk.?

The current yield on the Merrill Lynch index is 7.9 percent. So, you?re looking at 8 percent or so returns for 2004, plus or minus 2 percent, Garman predicts.

If the economy does well, there will be price erosion, he concedes, as interest rates finally start their long-awaited climb. If the economy softens, you might see some price appreciation.

This said, Garman explains that junk bonds will be less affected by rising rates than other fixed-income securities, like Treasurys. ?It (high yield bonds) is relative interest-rate insensitive,? he explains.

This is due to the credit component. Investors more focus on these issuers? ability to make their timely interest payments. So, an improving economy increases the likelihood that a company will make these payments.

Indeed, even Citigroup recommends that moderate/aggressive accounts should devote 15 percent of their fixed-income portfolios to high yield bonds.

But be careful. Merrill?s Garman warns to watch the trend in defaults. He cautions, ?If defaults head higher, it?s a negative.?
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.