Rush to Junk Bonds May Be Onto Thin Ice

Are small investors being foolhardy, or are they smarter than the pros? At a time many sophisticated investors are worried about high-risk, high-yield--”junk”--bonds, the general investing public is flocking to put money into junk bond mutual funds.

The attraction is simple. With interest rates on certificates of deposit and money market funds declining--most are paying less than 9%--yield-seeking investors are scrambling for the 12%-and-greater interest paid by high-yield funds.

Investments in such funds--which seek to reduce the risk from default in any one junk bond by investing in many--rose more than $900 million in May. That brought total assets in junk bond mutual funds to $34.5 billion--20% above year-ago levels and roughly 19% of the junk market’s estimated $180 billion in total value. And the beat goes on. T. Rowe Price Inc., one of the largest fund distributors, says its high-yield fund took in $42 million in June, up 35% from May.

But the safety of high-risk, high-yield bonds is not so simple. Companies issuing junk bonds pay high interest, after all, to compensate investors for the risk that cash receipts of the business won’t be sufficient to pay bond interest or long-term profitability adequate to assure repayment of principal at maturity.

Just how risky such bonds are is the subject of debate. A recent study by Harvard University calculated a higher risk of default than had been thought previously. On the other hand, a study paid for by junk bond issuers said Tuesday that the high-yield issues are only slightly riskier than other investments.

But such studies, which depend on abstract pricing formulas, understate reality. What small investors should understand about the junk bond market is that prices often are what traders say they are in a freewheeling, over-the-counter market. Fluctuation can be dramatic.

Pros Are Worried

The market recalls Benjamin Graham, the renowned value investor who in his great book “The Intelligent Investor” wrote of “real estate bonds of the 1920s. Billions of dollars of these bonds were sold at par and widely recommended as sound investments.” Yet, “a large proportion had so little margin of value over debt as to be in fact highly speculative in character. In the Depression of the 1930s an enormous quantity of these bonds defaulted their interest and their price collapsed--in some cases below 10 cents on the dollar.”

At that price, Graham goes on, they were well worth buying--although they were no longer recommended.

Today’s investors may shrug off tales from the Depression as ancient history, but things have been happening lately in junk bonds that worry market professionals. There was the Chapter 11 bankruptcy last month of Integrated Resources, a major junk bond issuer. The bonds fell to 23 cents on the dollar, according to Grant’s Interest Rate Observer--a newsletter that is skeptical of high debt.

Then there is the liquidation of $160 million of Drexel Burnham Lambert’s high-yield unit trusts--portfolios of junk bond issues sold as a unit, but lacking the active management of a mutual fund. Drexel--the firm that dominates the junk bond market--decided as a consequence of its getting out of retail brokerage to liquidate 11 unit trusts by selling the bonds. The firm says the realized price will be 18% below par value, which means trust investors will take an 18% reduction in principal.

“Investors will break even,” says a Drexel spokesman, “because of the 14% interest” they have been receiving on the units, which were sold in 1984 and ‘85, and again in 1987. Could be, but it’s a hard way to break even. If investors held trusts for two years, they stand to make 5% a year; if they held for three years, 8% a year, or as much as they could have made in risk-free government bonds.

Meanwhile, one big worry about junk bonds today is that with consumer spending flat and the economy slowing, department store companies that were involved in junk bond takeovers and restructurings in recent years may not have the cash flow to meet interest payments.

The junk bonds of Carter Hawley Hale and R. H. Macy may be all right--both sell at a premium to face value. But the bonds of Allied Stores, taken over by Campeau Corp. of Canada in 1986, now sell for 60 cents on the dollar, and the bonds of Federated Department Stores--acquired by Campeau last year--sell for about 95 cents on the dollar, even though they promise a whopping 16% interest payment.

Federated’s bonds might sell for even less, says a junk bond analyst, but investors figure the company’s properties--such stores as Bloomingdale’s, Lazarus, Foley’s and Burdines--could be sold in a pinch to pay the company’s debts.

By now, you may begin to understand why such bonds are called high-risk--and why small investors may be rushing in where smarter ones fear to tread.