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Trade your Treasurys for junk
They're rising as the economy slowly rebounds, and while the easy money has been made, there's still time to get in. Junk-bond funds have a place in most portfolios.
By Timothy Middleton
From November 2001 through June 2002, the default rate on high-yield bonds remained above 10%. It was the first time since the Great Depression that corporate debt had suffered such a calamity.
But its aftermath is a junk-bond market cleansed of its shakiest paper. Between October and March, the average junk-bond fund spurted 11.5%, according to Morningstar. Some 5.4% of that came in this years first quarter.
Including the first quarter, weve had four quarters in a row of economic growth, of roughly 1.5%, says Margie Patel, manager of Pioneer High Yield Fund (TAHYX), which has advanced 10.2% in each of the five years ended April 23. People have become a bit more optimistic.
The optimists include Warren Buffett, whose Berkshire Hathaway (BRK.A, news, msgs) last year increased its investments in junk sixfold to $8.3 billion. Buffett has been chased by individual investors, who shoveled $555 million into junk funds in just the week ended April 16 -- 65% of all inflows into taxable bond funds.
There's still time
Ive been recommending a switch from Treasurys to corporate bonds, and especially junk bonds, since last August. If you still havent made the move with at least some of your fixed-income kitty, youve missed the easiest money.
But the junk market is far from topping out. Spreads, or premiums above the yield of Treasurys, have contracted to an average of 650 basis points, from a peak of 1,070 last October, according to Merrill Lynch. Over the long haul, they average 530 points, and can contract to as few as 300 in boom times, such as 1998. (One hundred basis points equal one percentage point.)
Meanwhile, you can enjoy yields of nearly 10% while you wait for junk-bond prices to continue rising.
As its name suggests, below-investment-grade debt is the stuff that bank trust departments cant buy for widows and orphans. And although such bonds are the poor relations of gilt-edge debt, they're numerous.
Companies are assigned low bond ratings because they're relatively weak financially. That also means they're very sensitive to the economy. Prosperity fuels sales that make it easy for junk-bond issuers to service their debt. Recession makes it hard, and even impossible. A rally in junk signals an improving economy.
Even after years of high defaults, the junk-bond market is huge, totaling some $645.9 billion at the first-quarter's end, according to Moody's. And defaults were worse than they appeared. The official default rate applied to issuers rather than issues. In dollar terms, nearly 20% of the entire junk market went into default, says Robert Cook, manager of Conseco High Yield Fund (CHYYX).
A corporate cleanup of sorts
But the carnage, as well as the accounting debacle surrounding Enron (ENRNQ, news, msgs) and several other companies with shaky financials, had a salubrious effect on corporations in general. In a down economic cycle, the best thing corporate managements can do is de-lever their balance sheets, says Cook, whose fund is up 12.6% this year, as of April 23.
Improved financial controls and a stronger economy have already driven defaults to just below 7% in March, from a peak of 10.7% in January 2002. The erasure of so much speculative paper has also made the whole group more creditworthy.
About 130 mutual funds target the junk arena, and about 90 of them have been around at least five years, which is the minimum amount of time a fund needs to demonstrate its mettle. Here's a screen you can use to begin your search for a high-yield bond fund.
Many bond investors prefer closed-end funds to mutual funds, because closed ends can employ leverage to boost yields. Typically they sell preferred shares or derivatives to boost assets and buy more bonds, with the increased dividends being shared by common and preferred shareholders.
| Highly leveraged closed-end funds | | Fund | Leverage | Premium | 12-mo NAV return | | Prospect Street High Income (PHY, news, msgs) | 53% | 16.8% | - 24.9% | | Van Kampen High Income (VIT, news, msgs) | 48 | 21.7 | 0.2 | | Zenix Income (ZIF, news, msgs) | 47 | 36.5 | 3.9 | | New American High Income (HYB, news, msgs) | 43 | 12.6 | - 11.7 | | Pacholder High Yield (PHF, news, msgs) | 39 | 19.4 | 1.2 |
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Notes: Leverage ratio to assets is as of most-recent reporting period. Premium to net asset value as of April 16. 12-month return as of March 31.
Source: Closed-end Fund Association
Perversely, however, leverage has gotten many closed ends in trouble. Last summer, amid the worst of the defaults, Prospect Street High Income (PHY, news, msgs), the most leveraged closed end, had to slash its dividend as its portfolio deteriorated. The shares, which trade like stocks on the New York Stock Exchange, tumbled to $2 from $4.50.
Prospect Streets managers -- and the managers of all the highly leveraged funds in our table -- didnt return calls for comment or, if they did, declined to be interviewed.
Another level of risk
Because of their higher yields, closed-end bond funds typically enjoy a share price higher than their net asset value -- nearly 17% higher, in the case of Prospect Street. The premium has the effect of reducing the effective yield of the fund to market level.
But that introduces another level of risk into these portfolios.
Its like stepping up to the plate with two strikes against you when you buy a fund at a large premium, says Thomas Herzfeld, a Miami investment adviser who specializes in closed ends. Not only do you have to guess right on the NAV, but also on the premium.
It happens, however, that at least one leveraged closed end, Conseco Strategic Income (CFD, news, msgs), has almost no premium, despite a yield above 10%.
Cook, who manages it, as well as the mutual fund, says he doesnt know why the market price of the closed end has a premium that, as of April 17, was only 2.9%. It could be the stigma of the name attached, he ventures.
The asset-management companys parent, Conseco (CNCEQ, news, msgs), is in Chapter 11 bankruptcy proceedings. But the asset-management business isn't in bankruptcy, and in any event, funds are owned by their shareholders, not their managers.
Meanwhile, the funds net asset value surged 10.6% in the first quarter, and its share price spurted 19.8% as a discount evaporated. About a third of the funds assets are leveraged, Cook says.
How junk funds fit
Junk-bond funds should have a place in nearly every fixed-income portfolio, and even equity investors may find them appealing in todays market. Most seers, including Buffett, predict that equity returns will average 7% for the foreseeable future, which is less than junk bonds yield.
I wouldnt gorge on the things, but I would definitely have them on my plate. They have some of the upside of equity, with less downside, and they are becoming less risky at the same time that government paper becomes increasingly exposed to the risk of rising interest rates.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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