`Junk Bonds Have Grown Up'

High-yield bonds are sizzling. Last year's record-breaking $120 billion in junk bond issuance pales in comparison with what's on tap for 1998. So far this year, $64 billion in junk debt has come to market, vs. $23 billion for the same period last year. Demand is so intense that yield spreads on junk have fallen to 300 basis points over U.S. Treasuries, 120 points less than the historical average. Moreover, investors are accepting poorer-quality issues that might not have succeeded only a couple of years back. "The market hasn't been this heated since the 1980s," says Ernest Monrad, the 22-year veteran manager of Northeast Investors' high-yield bond fund.

That decade, of course, ended with a crash. But bond mavens are betting this hot market won't end similarly. They note that a lot has changed since the '80s, when junk was used to fund highly leveraged transactions that ran aground. "Junk bonds have grown up," says Bart Geer, portfolio manager for State Street Research High-Income fund. Indeed, today's market features less leverage, more liquidity, and a more diverse group of investors. What's more, the robust economy has resulted in strong returns and average default rates of just 2%, down from 10% in 1989.

For those reasons, high-yield bonds are considered safer and more desirable than they were a decade ago. That's especially true now because "their high coupons act as a cushion against a market decline," says Margaret Eagle, portfolio manager of Fidelity Advisor High-Yield fund since 1987.

SURVIVORS. So how should you play the junk market? Financial advisers recommend shunning individual high-yield issues and focusing instead on funds with solid, long-term records. To find these steady performers, we looked for funds run by veteran managers who have lived through the pain of the crash and have 3-, 5-, and 10-year returns in the top half of their category (table). Managers with this kind of track record might be better able to handle any downturn if the economy should slow. Many of the steady winners currently like bonds from cable-TV and local phone companies. Eagle observes that "these companies are insulated from Asia," which eventually could pose problems for the U.S. economy.

Also sticking close to home is Seligman High-Yield Bond Fund. Manager Daniel Charleston buys only domestic issues by high-margin businesses with strong cash flow. One example: Pinnacle Holdings, which owns towers used for pagers, cell phones, and other telecom services. But Northeast Investors' Monrad and his co-manager and son, Bruce, shun telecom issuers. "Many of these companies have negative cash flow, and we don't know which ones will succeed," says Bruce Monrad. Instead, they see value in gaming issues such as Trump's Atlantic City and Boyd Gaming. They're also interested in the budding European junk market, which is getting a strong push from the euro's birth and investor flight from Asia.

The long-term winners we selected aren't always the junk market's sexiest performers. But right now, you're probably better off sticking with funds that "plod along with consistently good records," says Merrill Lynch global high-yield strategist Martin Fridson. That could help shield you from disappointment later on. Says Fridson: "Slow and steady wins the race."

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