The Lowdown on High-Yield Bonds

Although yields on most fixed-income investments have fallen to dismal levels, individuals can still find double-digit returns from investments in certain types of corporate bonds.

Bonds issued by such well-known companies as Chrysler Corp., Unisys and Kroger, for example, promise investors yields in the neighborhood of 10% to 14%.

What’s the catch? Risk. And lots of it.

These companies--and hundreds like them--have borrowed heavily. As a result, they pay higher interest rates because investors are shouldering a higher risk of default. The pejorative term for corporate debt issued by such highly leveraged companies is “junk bonds.” But some just call these bonds “high-yield securities.”

At times, both names are accurate. Some highly leveraged companies reward investors generously by continuing to pay on their debts until the debts are paid off or refinanced. Investors get high yields and few headaches. But other companies default, and some file bankruptcy, which frequently leaves investors with securities that yield nothing and plunge in value--junk.

In 1991, 341 companies, representing 6.8% of the junk bond market, defaulted on their debts, said C. Richard Lehman, president of the Bond Investors Assn.

How do you sift the high-yields from the junk? It’s not easy.

Before anyone considers buying a high-yield bond, they need to do some homework, said Jay H. Lustig, director of the high-yield department at Drake Capital Securities in Santa Monica.

“If you are loaning your money to some entity, you have to take the same steps you would take if you were loaning the money to your deadbeat brother-in-law. You have to say, ‘If I loan you this money, what assurance do I have that you are going to pay it back?’ ” Lustig said.

Those answers should appear in the company’s financial statements. Investors need to look for a handful of key numbers, Lustig advised.

First they should see whether the company’s revenue is rising, falling or leveling off. That should give a picture of whether the company’s future is bright or dimming. There are sometimes mitigating circumstances but, generally, you want the company’s revenue to be climbing.

Then look at cash flow figures. Often, companies will list cash flows on a separate page near the back of the financial statement. What you want to look at--and it may not be easy, since there’s no standard reporting format--is earnings before payment of interest, taxes and depreciation. That tells you how much money the company has to pay on its debts.

Now look at the company’s interest expenses. If cash flow is twice the amount of interest expense, this company’s bonds are probably a good bet, Lustig said.

However, before you get out your checkbook, you should also search the financial statement’s footnotes for upcoming payments of principal that may be coming due.

Just as homeowners sometimes have balloon payments on their mortgages, companies occasionally have balloon payments on their corporate debt. If such a payment comes due, the company’s cash flow must be sufficient to cover both the balloon payment--principal--and the interest expense for that year.

Some companies will argue that they don’t need the cash to pay the balloon payment because they have every intention of refinancing the amount. However, good intentions sometimes fall to bad credit ratings. In other words, if you’re looking for some certainty in your investment, you shouldn’t count on a debt-ridden company’s ability to refinance.

These analyses should help you determine whether a company is likely to pay on its debts over the coming year. However, those who invest in junk bonds should continually recheck the financial statements to determine whether the risks of their investment are growing or diminishing.

Not surprisingly, many experts in the field believe that this is no game for amateurs or for those who can’t afford to risk any principal. Consumers can invest in junk through mutual funds too, although dealing with a mutual fund does not eliminate the risks.

Investing in junk bonds is much like investing in growth stocks, Lustig noted. You accept a reasonably high degree of risk for potentially gratifying rewards.

How rich are the rewards? Obviously that depends on exactly which issues you invest in, but junk bond mutual funds posted a total average return of 36.37% in 1991, according to Lipper Analytical Services.

That’s the good news. The bad news: The year before, the average return on junk bond mutual funds was a negative 11.08%, according to Lipper.