Prospects for Junk Bonds Remain Bright for ’93

The best investment of 1992 was junk. Junk bonds, that is.

According to recently released figures from Lipper Analytical Services, which tracks mutual fund performance, funds investing in high-yield junk bonds returned 17.69% in 1992. That beat the total return of blue chip stocks by more than 10 percentage points. It was about 15 percentage points richer than the returns on money market funds. It even outpaced the total return on growth stocks.

And if you think that’s impressive, consider 1991, when junk bond funds earned 36.37% on average.

Thanks, in part, to stellar returns like these, high-yield bonds that became notorious in the bankroll-’em-and-bankrupt-’em 1980s have now gained cache. And many industry experts believe that despite the inherent risks of investing in the debt of highly leveraged firms, junk is likely to be one of the top investments in 1993 as well.

“Junk bonds will continue to outperform all other taxable fixed-income securities, and they might outperform equities,” said John Lonski, senior economist with Moody’s Investors Service in New York.

There are several reasons why the prospects for junk bonds remain bright.

Namely, the U.S. economy seems to be improving, which bodes well for companies and those who invest in them. Normally, economic recoveries can bring inflation and rising interest rates, which is bad for the bond market in general. (Investors frequently dump old lower-rate bonds and invest in higher-yielding alternatives when interest rates rise. That depresses the price of existing bonds.)

But junk bonds are less hurt by interest rate hikes than higher-quality bonds. That’s because their trading price is as much a function of credit quality as it is of interest rates. When the economy improves, credit quality does too, which tends to offset the interest rate impact.

Additionally, the initial public offering market has soared. And that’s allowed highly leveraged companies to raise capital by issuing stock. Many firms have consequently paid off much of their debt, leaving them significantly more credit-worthy.

Defaults on junk bonds fell to about $7.9 billion in 1992--about 2% of the market--compared to $23.3 billion, or 6.3% of the market, in 1991, said C. Richard Lehman, editor of the High Yield Securities Journal in Miami Lakes, Fla. Defaults should drop to about $5 billion this year, he adds.

Still, all this positive news doesn’t mean that the risks involved in junk bond investing have evaporated.

Junk bonds are still thinly traded, which means that anyone who is forced to sell in a hurry may have to accept a cut-rate price. And although default rates have fallen, junk bond issuers are still more likely to default than issuers of high-quality corporate or municipal bonds.

Nonetheless, investors who can tolerate a bit of risk may be able to significantly boost their investment returns by putting at least a portion of their assets in junk.

Most investors are well-advised to limit their junk investing to mutual funds, however. That’s because diversification is particularly important in volatile and risky markets, such as this one.

To properly diversify a junk portfolio on your own, you’d probably have to pour about $200,000 into the bonds of various companies, said Ronald Vannuki, managing director of Drake Capital in Santa Monica. Since many experts believe that you shouldn’t put more than 10% to 20% of your investments in junk, you’d need to be very wealthy to invest in junk on your own.

There are about 70 mutual funds that specialize in junk bonds, notes Margaret D. Patel, portfolio manager of Advest’s Advantage High Yield Bond Fund. But investors should realize that all junk bond funds are not alike. Some are far riskier and far more volatile than others, she said.

Patel’s fund, for example, is among the riskier options. It invests between 40% and 60% of its money at any given time in convertible securities and concentrates on some lower-rated securities. But it has also posted strong results lately, with a 27.57% total return in 1992 and a 46.48% return in 1991.

But in 1989 and 1990, when the junk market was ailing, Patel’s fund suffered more than the average. It lost 14.58% in 1990 and was down 8.81% in 1989.

Some junk funds hold the bulk of their assets in higher-grade junk. That depresses their returns when the junk market is soaring, but it limits the possibility that the fund will decline significantly in value too.