Junk Bonds Not Living Up to Their Name

The last place anyone might think of as a safe haven for their money is the junk bond market.

Remember junk bonds? They were the securities embraced by Michael Milken, who used them to finance scores of corporate takeovers in the 1980s. They ended up crippling companies under crushing debt and forcing layoffs and failures.

But stack up the performance of junk bonds against corporate bonds and the results are eye-opening. Junk bonds, also known as high-yield bonds, have consistently beaten corporate bond funds over the last 10 years.

In 1995, for instance, 151 junk bond funds had a cumulative 16.37% return, compared with 15.63% for 642 corporate bond funds, according to Morningstar Inc., a Chicago-based firm that tracks the mutual fund industry.

And for the first half of this year, junk bonds had a total return of 4.81%, compared with a negative 0.90% for corporate bond funds.

“This has been the year to own the Kmarts of the world,” said Mark Wright, a Morningstar analyst who follows the junk bond market.

Unlike the highest-rated bonds, which are rated AAA, junk bonds are speculative because of the greater risk that the issuer will fail to pay interest or repay principal. They are issued by companies heavy with debt and pay higher yields because of the risk.

A junk bond rated “BB” indicates the lowest degree of speculation, while one rated “CC” is the highest degree of speculation.

Investors should have at least 5% to 10% of their portfolio in junk bonds, some experts say.

“They offer good diversification from stocks,” Wright said.

“When I look at my portfolio, I want to try to own as many different types of assets that will behave differently,” he said.

But junk bonds carry plenty of baggage. Their name alone doesn’t inspire confidence.

“People tend to think those are very high-risk investments, but only about 3% of junk bonds per year go unpaid or the companies go belly-up and file for bankruptcy,” said Tom Byrne, director of research with Individual Investor Group, a financial publishing and money management firm based in New York. “They are probably not as risky as most people think.”

Junk bonds are frequently associated with reckless practices of the 1980s, when billions of dollars were raised to finance the acquisition of companies that weren’t credit-worthy.

“It is still a controversial investment,” said Mark Vaselkiv, president of the T. Rowe Price High Yield Fund and executive vice president of the T. Rowe Price Corporate Income Fund. The best way to invest in junk bonds is through mutual funds, which offer variety and a cheaper way to get into the high-yield market.

Some top-performing junk bond funds include Janus High Yield, which was up 13.96% in the first half of this year; Strong High Yield Bond, up 13.89%; and Touchstone Income Opportunity A, up 11.58%.

Price’s Vaselkiv runs a fund with $1.2 billion in assets under management, and he invests in high-quality junk bonds rated “BB” and “B.” “We don’t want to take huge bets,” Vaselkiv said. “You have to pay attention to risk control. If you don’t, you can really get hammered.”

But the junk bond market has been holding up quite well, thanks in part to a healthy economy.

“The downside is clearly if we go into a recession,” Vaselkiv said. “A lot of my portfolio will be affected. But it looks to me like corporate earnings are strong. This is the ideal environment for junk bonds.”