‘Junk Bonds’ Become Fashionable Again, but Look Before Leaping

“Junk bonds’ have suddenly become less junky.

At least that’s the sentiment of thousands of individual investors who are flocking back into mutual funds that invest in the risky bonds. Lured by juicy yields as high as 14%--and less thrilled by falling yields on money market mutual funds and Treasury bills--investors have placed hundreds of millions of dollars into junk funds in the past six weeks, reversing plummeting sales in March and April, fund companies report.

But does that mean you should jump on the junk bondwagon?

Maybe. Investing in junk could make sense, but only as part of a diversified portfolio that includes other, safer investments. And you should shop around, because not all junk bond funds are the same or carry the same risks.

The move back into junk is not totally irrational.

Junk funds last year posted a nice 12.44% total return (interest plus capital gains), beating funds investing in safer corporate and government bonds.

Their performance so far this year has been lackluster, with many funds posting total returns of less than 3%, according to Lipper Analytical Services. That is largely because junk bond prices have fallen amid recession worries, offsetting part of their high yields. Investors were justifiably concerned that if a recession comes along, many junk-issuing corporations may suffer earnings declines and thus fail to make interest payments, leading to widespread defaults.

No one knows for sure just what the junk bond default rate might be in a downturn, because the modern $190-billion junk market has never really gone through a full-blown recession. But some estimates say more than 10% of junk bonds will default, up from about 2% to 3% now.

But because prices have fallen, yields on junk bonds have risen. The difference in yields between junk bonds and far-safer Treasury bonds has widened to about 5 percentage points, one of its highest levels ever. That difference may now be high enough to offset the added risk of junk.

Another factor helping junk bonds has been the surprising ability of the market to absorb a flood of recent new issues, led by the record multibillion-dollar issue of RJR Nabisco bonds to finance a leveraged buyout of the giant food and tobacco concern. With that offering out of the way, fewer new issues are in the pipeline. That should help keep bond prices higher.

Yet another encouraging factor: Many junk bond fund managers are moving to reduce risks by investing in bonds of companies that are more likely to weather a recession. Managers also are moving into bonds that are more actively traded, making it easier to sell them.

Some funds, such as T. Rowe Price High Yield Bond Fund, are also using futures contracts or other hedging techniques to reduce risk. Other funds are moving more into cash or into investment-grade bonds.

Also, some fund companies, including T. Rowe Price, are planning to issue new brochures or other educational material to make sure that investors understand the risks. “We are concerned that investors are going after yield without understanding the risk,” says Steve Norwitz, a spokesman for T. Rowe Price.

Unfortunately, many investors are jumping back into junk without exercising the caution that such investing requires, fund officials say. For example, some investors say they are putting most or all of their investable money into junk funds, says Brian Mattes, spokesman for the Vanguard Group, a large fund company.

Perhaps some investors think that they can bail out of junk funds before a recession starts. But that is not so easily done. In the first few days following the October, 1987, stock market crash--which ignited fears of recession--junk fund share prices plummeted so fast that many investors could not get out of them in time.

“Markets move very quickly,” says John Markese, director of research at the American Assn. of Individual Investors in Chicago.

Another common misperception is that junk bonds, like other bonds, will gain in price with falling interest rates. That may be true to some extent, but don’t count on it. Junk bonds move more with the state of the economy--rising with strong economic growth, falling if recession nears. Evidence of that came with their performance right after the 1987 stock crash, when interest rates fell but junk bond prices fell as well.

Another common problem among investors is their failure to shop adequately for funds. Junk bond funds are more like stock funds than bond funds, Markese says. Some junk funds invest in far riskier bonds in order to jack up their yields. But few investors study the risks each fund takes to achieve its high yield.

“People will spend days researching yields but won’t take a minute researching credit quality,” Vanguard’s Mattes says. “That’s unfortunate.”

Lori Lucas, a junk bond fund analyst at Mutual Fund Values, a Chicago-based advisory service, notes that some funds “have a policy of getting yield at any price.” Among funds with the riskiest junk are Bull & Bear High Yield and Alliance Bond High Yield, she says. You can give up just a little bit in yield and get a far safer portfolio, she suggests.

To research credit quality, call and ask for the quarterly, semiannual or annual reports of the funds you are interested in. There you will find a listing of their portfolio.

If it appears to be out of date, don’t hesitate to call the fund and ask what major changes have been made in the fund.

If you are concerned about risk, look for funds that invest in junk bonds of relatively recession-resistant companies, Lucas suggests. These include firms in such industries as food, media, gaming and hotels, waste management and telecommunications. Lucas also advises to look for bonds of utilities and financial services firms, excluding savings and loans.

Also look for bonds of recognizable large companies, for these issues are more likely to have higher trading volumes and thus are more easily bought and sold.

But be aware, she says, of bonds of firms in such cyclical industries as steel, autos, railroads, transportation and textiles.

Some funds, such as SteinRoe High Yield Bond, only invest part of their money into junk bonds, Lucas says. Their yield is lower, but they will be less likely to lose value in a recession.

Another suggestion: Look for larger funds with, say, $1 billion or more in assets, that have sizable holdings of bonds of many firms.

“In a down cycle, you know you’re going to see more defaults,” T. Rowe Price’s Norwitz says. “The only real protection is being well diversified. If there’s a default in one or two of the issues, that shouldn’t have a major impact on the value of the whole fund.”

Also look for funds with low annual expenses, preferably less than 1%, Markese suggests.