Why Junk Bonds Are Back in Style
The corporate junk bond market is attracting a wave of new money from yield-hungry investors--just weeks after suffering the worst cash outflow in almost two years.
The $1.8-billion Franklin AGE High-Income junk mutual fund in San Mateo, Calif., which lost nearly 5% of its assets in October as investors pulled out, has already seen half of that money return since Nov. 1, the fund says.
Other junk funds also report a surge of buying activity. “Interest has really increased this month,” says Thomas Ole Dial, manager of the National Bond fund in Greenwich, Conn.
The quick turnaround in junk is fortifying many experts’ view that these high-yield corporate bonds remain a good investment story for the year ahead. If the economy improves while interest rates overall remain under control, junk bonds could rank among the most lucrative investments for a third straight year in 1993.
Even so, the junk market’s whirlwind moves this fall should remind everyone that these aren’t investments for the meek. The phrase “subject to change without notice” strongly applies here.
For almost two years through September, junk bonds had consistently turned in stellar returns as yields remained generous while defaults by junk issuers--typically high-risk companies--declined dramatically.
In October, however, the junk market’s long rally abruptly halted. Junk experts blame a confluence of events, including the general rise in market interest rates over election worries, a rush of new junk bond issues and the plunge in value of Marriott Corp.’s bonds after the hotel giant announced a controversial plan to split itself.
Whatever the trigger, big investors who try to time bond market moves via mutual funds decided that the junk market was ripe for profit taking. As one after another of these market-timers pulled their money out of junk funds, the funds were forced to sell bonds to raise cash, or at least postpone new purchases. A cascading effect kicked in, quickly depressing the value of junk issues.
But some news accounts of the junk bond outflow during October suggested far worse damage than what actually occurred. Consider:
* The average junk bond mutual fund suffered a net decline of 1.64% in October, according to fund-tracker Lipper Analytical Services in New York. Yet even with that loss, the average junk fund boasts a total return (interest earned plus the bonds’ rise in value) of 14.1% this year through Nov. 5, after rocketing 36.4% in 1991.
* The average U.S. government bond mutual fund lost 1.36% in October, hurt mostly by the rise in market interest rates. So government funds’ loss was only slightly smaller than junk funds.
“People didn’t talk about the fact that higher-quality bonds were off almost as much as (junk) in October,” says National Bond fund’s Dial.
Meanwhile, because junk funds’ yields are far above government bond yields, the junk funds’ cushion for trouble is that much bigger. So far this year, the average junk fund’s total return of 14.1% is nearly 10 percentage points above the average U.S. government bond fund return of 4.5%.
What probably frightened many junk investors in October were memories of the junk market’s collapse in 1989 and 1990--as the economy careened into recession and many companies that had gone heavily into debt in the ‘80s went belly-up, sinking their bonds.
But the junk market today bears no resemblance to the market of two years ago, analysts say. If you’re a long-term investor rather than a market-timer, here’s why many junk experts believe that these bonds will be worth owning in 1993:
* A stronger economy next year should boost corporate profits, which would be of greatest significance to the higher-risk companies that have issued junk bonds. Thus, they should be perceived as healthier financially.
That in turn should give investors greater comfort in owning junk bonds. So even if market interest rates overall rise with an economic recovery, junk bond yields may not rise as much as, say, Treasury yields. Remember: Sharply rising rates are bad for bond mutual funds because they depress the value of older bonds in the portfolio.
* Even if the economy remains slow, junk bond defaults aren’t expected to rise significantly next year. “Most of the companies that needed to be restructured have already done so,” says Christopher Molumphy, senior portfolio manager at the Franklin AGE junk fund.
In this year’s wimpy economy, the volume of junk bonds that went into default totaled $7.5 billion in the first three quarters of the year, says Richard Lehmann of the Bond Investors Assn. in Miami Lakes, Fla. In contrast, defaults totaled $28.5 billion in 1990 and $23.3 billion last year. (The total size of the junk bond market is somewhere between $200 billion and $300 billion.)
* Short-term interest rates remain woefully puny. That should continue to encourage investors to look for higher yields elsewhere. And junk bonds remain the highest-yielding securities around.
What are the big risks? A continuing surge in junk-bond refinancings could burden investors from time to time, causing them to pull away simply because supply temporarily exceeds demand. Likewise, a major, unforeseen international crisis could force interest rates up and the economy down, a double-whammy for junk bonds.
But if the 1990 junk crisis and subsequent enormous rally proved anything, it’s that investors who stay put in these securities ultimately make very good money. You’re taking higher risk, but you’re earning a higher return to compensate. That’s how investment theory is supposed to work, and it hasn’t been repealed yet.
‘Junk’ Takes a Hit
High-yield corporate junk bond mutual funds mostly fell in value in October. Even so, most of the funds are up dramatically this year. Here’s a look at 10 big junk funds, their total returns (interest earned plus capital appreciation) for October and the year-to-date, and the interest each has paid over the last 12 months.
Total investment return: 12-mo. Fund Oct. Yr-to-date yield Fidelity Cap. & Income -1.02% +23.9% 8.2% Prudential High Yield B -1.50% +12.4% 10.8% Putnam High Yield -1.61% +16.4% 12.5% T. Rowe Price High Yield -1.65% +11.2% 10.1% Franklin AGE -1.75% +14.4% 10.4% Kemper High Yield -2.18% +13.4% 10.7% IDS Extra Income -2.21% +16.6% 10.7% Dean Witter High Yield -2.43% +22.6% 9.9% Vanguard High Yield Corp. -2.50% +10.9% 10.2% National Bond -3.53% +23.3% 12.6% Avg. high yield fund -1.64% +14.1% 10.5% Avg. U.S. govt. fund -1.36% +4.5% 7.2%
Year-to-date returns are through Nov. 5.
Source: Lipper Analytical Services
