This hot performance the best since the 1 980s-has come despite the fact that the yield spread for junk bonds over ten-year Treasury bills is a modest three percent. All of which raises several tough questions if you're an investor thinking of buying high-yield bonds, either directly or through mutual funds.

Is the spread too narrow? Is a mere three percentage points in yield over Treasuries worth the risk when you could just as easily buy blue chips or Treasuries themselves? In fact, some experts point out that the yield spread is actually around 100 basis points less than it appears, given defaults, distressed exchanges (issuing new bonds with more lenient payment terms when the company can't make payments on the old bonds), and aggressive call features. Considering the average spread was 5.6 percent over the last 11 years, and as high as 11.7 percent in 1990 with an average yield of 17 percent (versus 8.6 percent now), some experts question whether it's worth investing in high-yield bonds today. However, others point out that it's the best deal going among fixed-income vehicles, and they're comfortable with the narrower spread as long as the economy continues to hum along.

What happens when the economy turns down? That's what worries investment experts about junk bonds. The default rate for junk bonds was a miserly 1.6 percent in 1996 (versus 3.5 percent the year before). But a downturn in the economy would almost assuredly turn "high-yield" into "junk" by pushing an increasing percentage of junk bond issuers into default.

Is too much money chasing too few good junk bonds? With so much money flowing into high-yield funds, some funds are foraging heavily among low-grade junk just to find something to buy for their shareholders and to keep yields up. These include bonds rated Caa by Moody's or CCC by Standard & Poor's-issues from companies that are near default now, let alone if the economy stumbles. Investors looking for higher yield also are buying up the flood of new issues from young, high-risk telecommunications companies. The robust economy has kept a lot of these marginal bonds afloat, but a downturn would almost certainly sink some of them.

Why buy junk bonds at all? High-yield bonds are attractive to investors seeking income. Nonetheless, investment advisors generally recommend keeping them to five percent or less of the portfolio. Furthermore, Ibbotson Associates reports that high-yield bonds are more correlated with the S&P 500 than investment grade bonds. They found that the correlation between stocks and junk bonds was higher during a recession than an expansion. In this light, some experts question whether the diversification value of junk bonds is worth it, considering the risk for the return.

Should one buy individual junk bonds or junk bond mutual funds? For most investors, even savvy ones, it's easier and probably safer going through mutual funds. The junk bond market remains relatively illiquid compared with most other markets, so selling individual issues can be tricky, and transaction costs are high. Plus, a bond fund will allow greater diversification from default risk.

September -30- 1997