The good times in the $850 billion U.S. junk bond market may be at risk of winding down as the economy slows, leveraged buyouts get bigger and an increasing amount of bond supply looms.

Junk, or high-yield bonds, those rated below investment grade, have defied predictions of a pullback since 2003, fortified by a buoyant economy and lower yields in other markets.

Although strategists do not expect a collapse, conditions will not likely improve from here, they say, and by one key measure, performance may have already peaked in May.

Spreads, or the difference between yields on junk bonds and Treasuries, likely hit their low for this cycle at 288 basis points on May 12, said Martin Fridson, veteran high-yield strategist and publisher of independent research service Leverage World.

Spreads tend to rise when investors expect a slowing economy and a rise in bond defaults.

Spreads have already widened by 54 basis points since May 12, according to Merrill Lynch data. That widening has translated into lagging returns on junk bonds versus Treasuries over the past three months, the first three-month losing streak since 2002, Merrill said in a report issued on Friday.

LBO CONCERNS RATCHET UP

There is absolutely no doubt that slower economic growth is detrimental to high-yield companies - they are the most sensitive to any changes in the macro environment, including importantly, changes in credit availability, said Mariarosa Verde, managing director at Fitch Ratings.

Many investment professionals still expect a respectable performance from junk bonds this year, with total returns of 5 to 6 percent. Year to date, they have returned 4.7 percent.

The amount of liquidity in the system has really helped credits basically keep their balance sheets relatively strong, said Ray Kennedy, head of the global high-yield team at Pacific Investment Management Co. in Newport Beach, California.

Still, he has been upgrading the quality of his high-yield holdings as a precaution against the potential for a slower economy and higher defaults.

The U.S. economy grew at just a 2.5 percent annual rate in the second quarter, down from 5.6 percent in the first.

A record $33 billion leveraged buyout of hospital chain HCA Inc. announced last month added to investors' anxiety. LBOs are a worry because the massive debt taken on to fund these deals undercuts a company's credit quality and adds to junk bond supply.

The real concern is not what the economy is going to do to high-yield, it's what the new-issue market and unfriendly bondholder activity is going to do, said Kingman Penniman, president of high-yield research firm KDP Investment Advisors in Montpelier, Vermont.

HIGHER DEFAULT PEAK EXPECTED

The optimistic view is that a pause in the Federal Reserve's interest rate increases on Tuesday will mark the end of its two-year tightening campaign, averting financing pressures on weak companies and allowing the economy to hum along at a slower but acceptable pace.

The Fed has raised rates 17 times since June 2004 to avert inflation.

If the Fed has successfully orchestrated a soft landing, with growth slowing enough but not too much, then high-yield companies may continue to perform well, said Fitch's Verde.

However, even in such a scenario, we expect default rates to go up in 2007 because credit and economic conditions are as good as they are going to get and corporate leverage is in fact beginning to turn up, she said.

Rating agencies expect defaults to rise only gradually and remain below historical averages for at least another year. Moody's Investors Service said the global junk bond default rate will likely rise to just 2.7 percent a year from now from 1.7 percent in July. The historical average is about 5 percent.

A more serious rise in defaults could occur, however, if the economy slowed below a 2 percent rate, according to high-yield strategists.

Whenever default rates do peak, they could top out at a higher level than the 10.9 percent peak of the last default cycle because the portion of companies with the lowest ratings is larger, said Leverage World's Fridson.

More than 17 percent of the high-yield market carried ratings in the CCC to C range last year, up from just 7 percent in 1996, according to Fridson's data. Ratings of CCC to C are the lowest next to default.

The end of the Fed's tightening could be the next catalyst for a change in the high-yield credit cycle, said Merrill Lynch high-yield strategist Christopher Garman.

Typically, when the Fed stops tightening, that marks the point at which default rates tend to creep up a bit, spreads tend to widen a bit and Treasuries tend to rally, he said.

California Investment