Junk Bonds Shed Their Trashy Image
Rather than buy stocks in this hot market, some money managers believe that they have a much better idea: junk bonds.
Despite the checkered past of these high-risk, high-yield corporate IOUs, their fans say the future should be significantly more rewarding for junk owners.
More rewarding, in particular, than what a lot of stocks may provide in the near term, given their current heights.
If the question is value, “anybody who is willing to invest in common stocks today but is unwilling to invest in junk bonds just isn’t being rational,” declares Glen King Parker, publisher of the Income & Safety mutual fund newsletter in Ft. Lauderdale, Fla.
The junk bond market crash of 1989 and 1990--sparked by the recession and the subsequent bankruptcies of many debt-burdened companies--was followed by a dramatic rally in junk bond values last year, as hopes soared for an economic recovery.
Yet, even with their ’91 comeback, annualized yields on many junk bonds still are very high--from 10% to 14%, generally. Because the majority of companies that issued these securities have never had a problem making interest payments, junk bond bulls say today’s yields represent a terrific opportunity for patient, long-term investors. And that should be true no matter what happens next with the economy or interest rates, the bulls say.
Here’s why:
* If the economy recovers strongly this year, the profit outlook for junk bond companies will improve as well--which should make their bonds appear less risky to investors. Thus, the potential audience for junk securities should grow in a better economy.
That, in turn, should help offset the negative effect on junk bonds of any rise in market interest rates that accompanies a recovery. Rising rates normally depress the value of existing fixed-rate bonds. But because junk yields now are so high, the bonds are less sensitive to a boost in market rates.
So far this year, for example, an index of junk bonds tracked by Merrill Lynch & Co. has posted a “total return” (interest plus bond price change) of 5.7%. In contrast, Merrill’s index of long-term U.S. Treasury bonds has dropped 3.1%.
So rising market interest rates this year have proven deadly to Treasury bonds, but not to junk.
* If the economy just muddles along in a slow recovery, and interest rates stay mostly flat, the stock market will probably continue to attract new investors--if only because of a lack of alternatives. And a healthy stock market is the junk bond market’s best friend.
With stock prices at record highs, many companies are issuing new shares to pay off debt. The trend has been especially pronounced among junk companies, many of which are firms that were taken private in leveraged buyout deals in the late 1980s.
As junk bond companies deleverage, they improve their finances and thus improve the margin of safety on any remaining debt they have. “So as long as the stock market does well this year, our market will do well,” says Dick Swingle, manager of the $1-billion T. Rowe Price High Yield fund in Baltimore.
* If the economy fails to recover this year, market interest rates are likely to slide anew. For investors who now rely on Treasury bonds for income--and who already are fed up with returns of just 6% to 7% on those securities--a further drop in those yields would make junk bond yields of 10% to 14% even more alluring.
Of course, a weaker economy also could send many more junk bond issuers into bankruptcy. However, a continuing economic slump in 1992 isn’t likely to have the same devastating effect on the junk market as did the recession’s arrival in 1990, simply because the weakest companies have already gone bust.
“The beauty of leverage is that your mistakes are washed out very quickly” when the economy sours, says Earl McEvoy, manager of the $1.7-billion Vanguard High-Yield Corporate junk fund in Valley Forge, Pa.
There will, however, still be more junk bond defaults--the term used when a company stops paying interest on its bonds. C. Richard Lehmann, who publishes the Defaulted Bonds newsletter in Miami Lakes, Fla., says another $25 billion to $27 billion in junk bonds could default this year. That would add to the $69 billion already in default, out of a junk bond universe of about $370 billion.
But junk default figures have become misleading. For one, many of the companies expected to default are already known, so their bonds long ago plunged in value--such as those of retailer McCrory Corp., which filed for Chapter 11 bankruptcy protection last week.
Also, bankruptcy creates an opportunity for a troubled company to forge a survival plan that can actually lift the value of its depressed junk bonds, by ending the uncertainty surrounding the company. “Prepackaged” bankruptcies are the trend, wherein bondholders and other creditors strike a deal in advance of the actual Chapter 11 filing. “Default by design has become very much in vogue,” notes Lehmann.
None of these arguments in favor of junk bonds is meant to suggest that they are risk-free investments. In fact, individual junk bonds will always be extraordinarily risky, by nature. The big attraction of the junk market today is simply that the risks appear much more reasonable when compared with the returns paid.
“You’re getting almost twice as much to go into (junk) bonds as high-grade bonds,” says Howard Marks, who manages a $1.5-billion junk portfolio for Trust Co. of the West in Los Angeles.
The average junk bond maturing in about seven years now yields 12%. In contrast, a seven-year Treasury note yields 6.9%. So junk pays you five more percentage points to compensate for the risk. For most of the 1980s, that spread was typically three points.
When the junk market began to unravel in the late 1980s, the bonds were crushed largely because investors weren’t sure how badly junk issuers would be hurt in a recession. Now, we know. Yet we also know that there are many sure survivors among junk issuers--including such major companies as Safeway grocery stores, cable TV leader Tele-Communications and tobacco giant RJR Nabisco.
Because these companies still are heavily indebted, more could go wrong for them--so their bonds should pay more than safer securities. Junk bulls simply believe that the bonds pay far more than their risk warrants.
There’s one major caveat in the junk bond pitch: You shouldn’t buy these bonds solely for their high yields, or for day-to-day income. Rather, says Income & Safety letter’s Parker, you should buy them for the same reason that you buy stocks--for their long-term potential.
Junk proponents believe that many still-depressed bonds will appreciate in value over time. When that appreciation is added to the bonds’ high interest rates, the result should be very healthy annual returns in the long run, even with inevitable defaults.
But can junk bonds really beat stock market returns over the next few years? At the very least, the current 10%-plus interest yields on junk give the bonds a head start. What’s more, even with last year’s junk rally, the bonds still are making up for ground lost in 1989 and 1990. If you’re looking for bargain investments, say many pros, you’re more likely to find them in the junk bond market than in the stock market.
Some savvy individual investors have recognized this over the past year, and it’s their cash that has flowed back into junk bond mutual funds after the gigantic exodus in the disaster years of 1989 and 1990. As junk bonds soared in value last year, these investors profited--at the expense of the investors who had panicked and abandoned junk bonds in their darkest period.
It’s a good sign that the investors who are buying these bonds today appear to understand them much better than the folks who bought in the late 1980s, when people began to believe that we’d never have another recession.
“The real sin of junk mutual funds in the 1980s is that they were sold as a substitute for money funds,” says Don Phillips, editor of Mutual Fund Values newsletter in Chicago. “It’s taken a while, but I think these funds are reaching the appropriate audience.”
Junk Yields: Back to Normal, Yet Still High
Yields on high-risk corporate junk bonds have fallen to their lowest levels since the first quarter of 1987 despite the recent rise in other interest rates.
