That’s Mr. Junk Bond to You : Healthy Economy, Few Defaults Have Brought New Respect for the High-Yield Securities

It’s certainly no secret that “junk” is back.

The bonds that fueled scores of corporate takeovers in the go-go 1980s have become a respectable investment in the 1990s. Many investment advisors now counsel their clients to hold at least a portion of their fixed-income portfolio in junk issues.

This wild child of the bond world has sharply outperformed its more staid corporate bond brethren, and also Treasury bonds, in the 1990s.

Junk mutual funds, more often called high-yield funds nowadays, posted an average total return (interest income plus capital appreciation) of 13.7% in 1996, compared with a 2.5% return for high-quality corporate bond funds, according to Lipper Analytical Services in New York.

“High-yield outperformed significantly in 1996 and has posted solid gains for about five years now,” said Alice Lowenstein, a fixed-income specialist at Morningstar Inc., a Chicago firm that tracks mutual funds.

In fact, the five-year average annual total return for junk bond funds is 11.5%, versus 7.7% for long-term U.S. government bond funds, Morningstar says.

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Unlike better-known corporate bonds of big-name companies, many of which carry top-notch AAA ratings, junk bonds are typically rated BB or lower and are often, but not always, issued by companies that don’t have long track records of sales or earnings. Other junk bonds come from “fallen angels,” companies that have fallen on tough times.

In any case, junk issues’ higher risk means the firms behind them must pay above-average yields.

The simple reason for junk bonds’ strong returns in recent years: Their high yields have more than compensated investors for the relatively few defaults that have occurred since 1991, as a healthy economy has enabled junk-issuing companies to stay afloat, make good on their debts and, in many cases, even prosper.

Investors’ growing acceptance of junk bonds led to record issuance last year, swelling the size of the entire junk market to an estimated $303 billion now, up from $178 billion in 1993.

With high-yield securities poised to record another strong year--as long as the economy stays on track--the challenge for investors in 1997 is how best to wade through the trash and find some undervalued gems.

Supermarkets and restaurants are two areas of opportunity for investors, predicts Amin Arjomand, a managing director with Dabney Resnick Imperial, a Beverly Hills securities firm. Both industries are seeing consolidation trends, so there are some smaller junk-issuing companies that may be bought by bigger players--which could lift the smaller companies’ bonds, now trading for 80 to 90 cents on the dollar, to full value.

Among supermarkets, Arjomand likes bonds of Farm Fresh Inc. of Norfolk, Va. He also likes bonds of Specialty Foods, a food manufacturer in Deersfield, Ill. “The ability to make above-average returns is very good right now” in those sectors, Arjomand said.

Jeffrey A. Koch, manager of the $365-million Strong High-Yield Bond Fund in Milwaukee (1996 total return: 26.8%), said his favorite junk sectors include the airline and finance industries.

Specifically, he owns junk issues of USAir Inc. in Arlington, Va., and savings and loan First Nationwide Holdings in San Francisco. Both USAir and First Nationwide, Koch said, will benefit from further consolidation in their industries and should see their fundamentals steadily improve, boosting the price of their bonds.

The home building industry could also be promising, according to Arjomand. His favorite play: bonds of Wickes Lumber Co., a Vernon Hills, Ill., firm that sells building materials in the Midwest, Northeast and South.

Analysts say the real sparklers in 1997 could be junk bonds issued several years ago by companies that are now considered troubled but may be poised for turnarounds. If the stock market stays healthy in 1997, some of those companies may be able to raise equity that will bolster their balance sheets and thus raise the value of their bonds.

Indeed, the performance of the junk market and the stock market are closely linked--which also means junk can have a rough ride if the stock market tanks.

For those who find buying individual bonds too risky, there are, of course, the junk mutual funds, in which an investor gives up some return for much more safety through diversification.

The net amount of new cash flowing into high-yield bond funds totaled $12.3 billion in 1996, a sharp increase from $8.1 billion in 1995, according to the Investment Company Institute. High-yield was the most popular of all fixed-income fund investments in 1996.

Still, Morningstar’s Lowenstein, along with many other junk experts, warns that junk returns this year may not approach last year’s big numbers. “It’s important for investors to remember that the gains have been quite strong now and we should lower our expectations for the near future,” she said.

Koch agrees. “I think this year will be more subdued than last,” he said. Even so, the fundamentals of the junk bond market are very good as the default rate is very low and credit upgrades have outpaced downgrades, he said.

Even a downturn in the stock market wouldn’t automatically concern him, he said. “It depends why it is dropping,” Koch said. “Our biggest concern is if the market is dropping because corporate earnings and corporate fundamentals are down because the economy is slowing. We just don’t see that on the horizon.”

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Top-Performing Junk Funds, 1996

Here are the top-performing junk bond mutual funds for 1996, ranked by total return (interest income plus capital appreciation). Also shown are returns for the average junk fund (there are 175 funds in all) and for the average U.S. government bond fund.

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1996 5-year 12-month (800) Fund return return yield phone Strong High Yield 26.8% NA 8.83% Touchstone Income 26.7% NA 10.00% 669-2796 Opportunity Fund A Janus High Yield 23.9% NA 8.50% 525-8983 Summit High Yield 22.6% NA 9.38% 554-3862 Salomon Bros. High Yield A 21.9% NA 9.66% 725-6666 Value Line Aggressive Inc. 19.7% 84.0% 9.07% 223-0818 PaineWebber High Income A 17.7% 75.6% 9.47% 647-1568 Phoenix High Yield A 17.2% 80.5% 8.84% 243-1574 State Street Research High Income A 16.9% 89.9% 8.82% 562-0032 Buffalo High Yield 16.7% NA 6.79% 492-8332 Average junk fund 13.7% 77.4% 8.79% Average U.S. govt. fund 1.7% 33.2% 5.99%

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NA: not available (fund did not exist for entire period)

In cases where funds are available in multiple classes, only the Class A shares are used in the ranking.

Source: Lipper Analytical Services

Junk’s Glitter

The junk bond market plunged in 1990 with the recession of that year and the demise of brokerage Drexel Burnham Lambert, the junk pioneer. But since then junk has outperformed the high-quality corporate bond market every year but 1995. Total returns for junk mutual funds versus high-quality corporate funds:

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High Junk quality 1990 -11.1% +6.8% 1991 +36.4 +16.4 1992 +17.7 +7.2 1993 +19.3 +11.3 1994 -3.8 -4.6 1995 +16.5 +18.5 1996 +13.7 +2.5

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Source: Lipper Analytical

California Municipal Bonds

T. Rowe Price & Associates tracks the yields of 20 California municipal bonds and the Bond Buyer Index of 40 national issues.

Five Widely Held California Bonds:

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Yield Issue Coupon Maturity 01/24 Friday Calif. general-obligation 10-yr (generic) 5.15% 5.10% Calif. general-obligation 20-yr (generic) 5.72 5.69 Los Angeles MTA (insured) 5.50% 7/1/17 5.77 5.73 Calif. public works lease rev. 6.00 10/1/14 5.87 5.82 San Fran. airport (insured) 5.65 5/1/24 5.84 5.80

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Source: T. Rowe Price & Associates in Baltimore, which manages a $150-million California bond fund

Note: All yields are as of 2 p.m. Friday. Yields are based on institutional trading, retail prices and a survey of California brokers. Yields offered to individual investors will vary.