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Junk Bond Funds' Yields Become Tempting As Their Risk Rises

By Werner Renberg

When the Federal Reserve's Federal Open Market Committee voted at its mid-year meeting not to raise short-term interest rates, investors in stocks and investment-grade bonds might have been encouraged.

But investors in sub-investment-grade corporate bonds, also known as high-yield or "junk" bonds, may have been a bit restrained.

Why?

Because a slower economic growth rate could cause more issuers of bonds rated double-B or lower to have difficulty paying interest and repaying principal. (Junk grades range from double-B through B, triple-C, double-C, and C. The four investment grades are triple-A, double-A, A, and triple-B.)

Indeed, even though the full effect of one year of a tighter Fed policy has not yet been felt, the default rate for high-yield bonds has already been creeping up. For the 12 months ended in May, according to John Lonski, Moody's senior economist, it was 5.4 percent, up from 4.7 percent for the previous 12-month span. It had been rising, despite the economy's growth, since the 12 months ended in September 1997, Lonski said.

Investors, of course, have not been oblivious to this. Concerned especially about the possibility of an increase in defaults that a recession could trigger, they have been insisting on higher yields to compensate them for the perceived increase in junk bonds' risk -- on top of the yield increase due to inflation fears and Fed tightening.

The result: an increase in the yield of the average junk bond, as measured by the Salomon Smith Barney High-Yield Market Index, from 11.41 percent -- or about 500 basis points above the yield of a benchmark for U.S. Treasury securities of comparable (intermediate) maturities -- at the end of 1999 to 12.88 percent, or about 650 basis points above the Treasury benchmark, at the end of May. (One basis point equals 0.01 percent.)

The increase in junk bonds' yields and decrease in their prices, naturally, has had predictable consequences:

* Owing to prices having fallen more than higher income could offset, the total return for the SSB index for the year's first 5 months was minus 3.6 percent.

* Lowest-rated junk bonds fared worst. The average triple-C bond returned a negative 4.6 percent vs. the average double-B issue's negative 2.1 percent. Among sectors, retail food and drug issues averaged a negative 19.9 percent.

* The average high-yield bond fund tracked by Wiesenberger had a total return of minus 3.8 percent for the same period (not adjusted for the sales loads of the category's load funds). The average principal-only return, which matters more to those who take dividends in cash instead of reinvesting them, would have been considerably lower.

* Redemptions of high yield bond funds' outstanding shares exceeded sales of new ones in nine of the ten months through May, according to the Investment Company Institute.

* With some prospective issuers waiting for interest rates to subside, the volume of new junk bond issues slumped from $139 billion in 1998 and $95 billion in 1999 to around $25 billion in this year's first half, Thomson Financial Securities Data reported.

If it's possible that a lower new-issue volume and pickup in demand could lead to lower yields, that the Fed may not soon raise short-term rates again, and that a near-term recession may be averted, would it be timely for you to think of investing in a junk bond fund -- provided that you understand the inherent risks?

Perhaps. However, even though it's possible that the recovery of lower-rated bonds may have more bounce, I would stay with no-load funds concentrated in "quality junk," such as Columbia High Yield Fund and Vanguard High-Yield Corporate Fund. They are less sensitive to credit concerns than funds concentrated in lower-grade junk, if more sensitive to changes in interest rates.

Columbia's fund had a total return toward the end of June of 1.1 percent, making it one of the few no-load high-yield bond funds tracked by Morningstar to have positive returns for the year to date. Among no-load funds with above-average 5-year records, it led for the last 12 months with 2.9 percent.

Because of market prospects, portfolio manager Jeffrey L. Rippey, who has run the fund for over five years, has been "consciously" upgrading the portfolio over the last six months, he said. At the end of May, it was about 40 percent in B bonds, about 50 percent in double-B, and about 10 percent in triple-B. Finding too few new bonds of acceptable quality, Rippey has been buying outstanding issues to put new cash to work. The Vanguard fund also had slightly positive returns: 0.5 percent for the year to date and 2.3 percent for the last 12 months. Earl E. McEvoy, senior vice president of Wellington Management, who has managed it since 1984, was similarly invested: 45 percent in B, 40 percent in double-B, and close to 10 percent in triple-B.

Both are permitted to have some bonds rated below B -- Rippey, 10 percent of assets, and McEvoy, 20 percent -- but they held essentially none.

Copyright © 2000 Werner Renberg. Reprinted with permission.