Jewels in Junk
For junk bond mutual fund investors, results show that thinking small may be a good strategy.
The $38-million Summit High-Yield Fund and the $50-million New England High-Income Fund, two relatively small funds whose portfolios focus on a limited number of securities, have turned in particularly good returns in the junk bond fund category--which has been just about the only type of bond fund many investors have wanted to buy in recent years.
This year, Summit’s total return is 12.3% through last Friday, according to Bloomberg Fund Performance, while New England has returned 9.7%. That puts both funds in the top 10% of junk funds, making them two of the best-kept secrets in that segment of the bond market.
The strategy of both funds is to keep things simple. Summit focuses on 45 holdings; New England just 38.
“It’s like you’ve got 45 little piglets at the feeding trough,” says Steve Sutermeister, manager of Cincinnati-based Summit. “If we find one that has a better total return potential, the new piglet is going to push out something we already have.”
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That game plan has made Summit the best-performing high-yield fund over the last three years, according to Lipper Analytical Services. It has returned an average of 17% each year since its inception in June 1994.
High-yield bond returns have beat Treasuries and investment-grade corporate bonds over one year, three years, five years and 10 years. Because junk bonds don’t closely track either stocks or bonds, fund managers say junk bonds are a good way to diversify and possibly capture healthy returns.
Investors in general seem to be growing more comfortable with junk bonds, perhaps as some grow wary of the surging stock market. Individual investors poured $7.25 billion into high-yield-bond mutual funds during the first six months of this year, according to the Investment Company Institute. That’s on track to beat the $12.3 billion invested last year.
Of course, such bonds are riskier than other bond investments and would be expected to do poorly in a deep recession.
When Gary Goodenough took over the $50-million New England High-Income Fund a year ago, it was a perennial under-performer with 138 holdings. He slashed that to 38, and now the fund has shot to the top of the charts.
With help from his research staff, Goodenough invested in companies whose credit rating he predicted would improve, which would boost their value.
“If we were right about the improving credit trend, the total rate of return would really be important to the fund’s overall performance,” Goodenough says. “That’s what happened so far, and that’s our plan for the future.”
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Investing in junk bonds, which are issued by companies with lower credit ratings, makes sense now, Sutermeister, Goodenough and other high-yield bond fund managers say. The balmy outlook on the economy suggests that these companies, many of them start-ups, will pay their debts on time--and won’t go bankrupt.
To compensate investors for their risk, junk bonds pay investors higher yields, now about 9.5% on average. Yet those yields have fallen in recent years with other long-term yields.
In fact, the interest rate difference between junk and U.S. Treasury bonds of the same term is historically narrow now--less than 3 percentage points. Still, analysts point out that that can still make an enormous difference in long-term performance.
Sutermeister, like many others in the junk bond market, prefers to use the phrase “high-yield” to describe his field.
“We don’t buy junk. We buy high-yield,” he says.
By whatever name, junk bonds are unquestionably riskier than Treasury issues or high-grade corporate bonds. Moreover, Sutermeister says he tends to make contrarian bets by investing in companies that have fallen out of favor with other investors.
One bet that’s paid off is Mobile Telecommunications Technologies Corp., which provides wireless paging service. The company’s bonds took a dive in February when investors fretted the company was running short on cash.
Mtel, as it’s known, was able to amend its line of credit, and its business is growing. Its second-quarter revenue was up 8% from a year ago, and it has sold 21,100 units of its new one-way pager, SkyWord Plus, since it was introduced at the end of April. Subscribers to Mtel’s two-way pagers almost doubled in the second quarter to 68,600.
“We thought the fundamentals were there and that eventually investors would return,” Sutermeister says. He bought Mtel’s 13.5% bonds due in 2002 at about $96 per $100 face value. They’re now at almost $110.
A couple of Goodenough’s picks have been AMF Group, the biggest maker of bowling equipment and owner of bowling lanes in the world, and Altos Hornos, Mexico’s largest steelmaker.
“Bowling is back. It’s really popular on a global basis,” Goodenough says. “The company has made strides in cash flow and consolidation.”
In another offbeat play, Summit invested in Pamida Holdings Corp., an Omaha-based retail chain. After getting slammed by competition from Wal-Mart, which forced the closing of about 70 stores, Pamida has bounced back. Its same-store sales rose 6.6% in the first quarter, versus a year earlier.
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Even if his fund grows to $100 million, Sutermeister wants to stick with his strategy and hold only about 45 names in the fund.
Summit hopes that the fund will grow more quickly now that it has a 3-year track record. Registered investment advisors and financial planners--who give the fund most of its business--tend to look for funds with a performance history of several years, says Dan Lunne, a regional sales manager.
“ ‘These guys are for real’ is what they may start to say,” Lunne says.
