As Investors Dump Junk Bonds, Fund Managers See Value

Just as investors are turning away from junk bonds for the first time in nearly three years, portfolio managers are smelling value.

As stocks have tumbled and talk has turned to the prospects for an economic slowdown, investors have stopped pumping money into long-popular junk bond mutual funds, which invest in lower-quality, high-yielding corporate debt.

Instead, an estimated net $817 million was pulled from junk funds in the first two weeks of August, according to Arcata, Calif.-based fund tracker AMG Data Services.

Yet portfolio managers argue that now may be as good a time as there’s been in almost three years for long-term investors to be in these funds, despite junk bonds’ obviously higher risk.

“As long as the Asian contagion doesn’t lead to a severe global recession, the prospects for high-yield bonds are actually very good,” said Ralph Stellmacher, manager of the $1.3-billion Oppenheimer High-Yield Fund.

Added Kathleen Gaffney, co-manager of the Loomis Sayles High-Yield Fund: “Generally, when things appear gloomiest is when you get the rock-bottom prices.”

To be sure, junk bond funds have under-performed of late.

The average high-yield corporate bond fund, according to the Chicago-based fund tracker Morningstar Inc., has lost 2.16% in the month from the recent stock market peak of July 17 through Monday, as some bond investors have fled to the safety of U.S. Treasuries amid the market’s turmoil, driving Treasury prices up--and pushing junk bond prices down.

Thus far this year, the typical junk bond fund has delivered a total return (that is, interest income plus or minus any change in share principal value) of just 3.07%, or about half the total return of the typical long-term U.S. government bond fund.

As a result of this under-performance, many fund managers now believe the high-yield sector provides them with something they haven’t seen since the beginning of 1996: real bargains.

A quick way to tell whether bonds are cheap, or not, is by looking at their yields.

According to Merrill Lynch, the current average yield on junk bonds is 9.3%, based on the firm’s index of high-yield bonds. That’s 3.89 percentage points above what 10-year Treasury notes now yield.

This difference is referred to in the industry as the yield spread.

Though 3.89 percentage points is still relatively narrow in historic terms, it is more than 1 percentage point greater than the spread as recently as September 1997, for example. Indeed, the gap hasn’t been this wide since January 1996.

Since bond yields move in the opposite direction of their prices, the widening spread between the yields of Treasuries and junk bonds indicates that the price of junk bonds, relative to Treasuries, is falling.

Ben Trosky, manager of the $1.9-billion Pimco High-Yield fund, notes that even relatively high-quality junk bonds are now trading at attractive prices.

“Take Qwest Communications,” Trosky said. The spread between the yield of this Denver-based telecommunications firm’s near-investment-grade bonds and 10-year Treasuries was recently just 1.8 percentage points.

But as the bond’s price fell, the spread grew to 2.65 percentage points--a bargain that Trosky could not pass up, he said.

Of course, junk bond yields are up for a reason. “The reward is higher because the risks are higher,” said Martin Fridson, Merrill Lynch’s director of high-yield strategy.

While government bonds are most vulnerable to fluctuations in market interest rates, junk bonds--officially, any bond considered below investment grade--are most vulnerable to what’s known as credit risk.

In essence, a junk bond will lose value as prospects rise that the underlying company might default on its debt. Since these securities are tied much more to the health of the company than to market interest rate fluctuations, junk bonds are a closer proxy to stocks than to other fixed-income instruments.

In troubled economic times, the likelihood that more companies issuing junk bonds will default--that is, fail to make debt payments--naturally increases.

Indeed, the default rate of junk bond issuers is rising. Bond-rater Moody’s Investors Service says the default rate for junk bonds in the 12 months ended July 31 was 3.08% of all junk issues’ principal value.

Though that figure was as low as 1.33% in February 1997, today’s rate is still well below the historic annual average of 3.4%, Merrill Lynch analysts note. The highest junk default rate: 12% in 1990.

Junk bond critics argue that default rates are likely to rise should Asia’s economic troubles and currency devaluations cut further into U.S. corporate earnings.

Portfolio managers concede that in a full-blown recession, all bets are off. But they also note that the majority of junk bond issuers are small to mid-size firms that are less dependent on Asian sales than large, U.S.-based multinationals.

Also, buying junk bonds through a well-diversified mutual fund should reduce an investor’s risks, because the effects of a handful of defaults will have little impact on the overall portfolio, notes Bob Kern, manager of the Safeco High-Yield Fund.

Loomis Sayles’ Gaffney says investors can further protect themselves by selecting a fund that invests in near-investment-grade debt--for instance, bonds rated BB. While investment-grade bonds are those rated BBB or higher, the junk bond universe is dominated by B-rated bonds or below.

“Why take additional credit risk?” Gaffney asked. “We’re sticking with top-tier companies that were previously investment-grade and that may have fallen down to BB.”

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How the Biggest Junk Funds Have Fared

Here are total-return figures for the 10 largest high-yield junk bond funds, through Monday. Shown are returns since July 17 (the recent peak for the U.S. stock market), year-to-date and five-year annualized. Total return is interest income plus or minus any change in principal value. Also shown is each fund’s most recent 12-month yield, which may be lower than the current yield.

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Assets July 17 5-year Fund (billions) to Mon.* YTD* (annual.)* Mer. Lynch Corp. High-Inc. B $5.5 -2.85% +0.81% +8.1% Vanguard High-Yield Corp. 5.1 -0.55 +4.57 +9.4 Kemper High-Yield A 3.9 -1.74 +3.48 +10.0 Franklin AGE High Inc. I 3.3 -1.30 +2.89 +10.2 Fidelity High-Inc. 3.2 -2.85 +5.48 +12.9 IDS Extra Inc. A 3.1 -2.27 +2.19 +9.3 Prudential High-Yield B 2.7 -1.87 +2.50 +9.0 American High-Inc. 2.6 -2.45 +3.35 +9.7 Fidelity Adv. High-Yield T 2.6 -3.08 +3.31 +10.8 Northeast Investors 2.6 -2.42 +4.54 +12.6 Average junk bond fund -2.16 +3.07 +9.2 8.3

12-mo. Fund yld.* Mer. Lynch Corp. High-Inc. B 8.6% Vanguard High-Yield Corp. 8.4 Kemper High-Yield A 9.2 Franklin AGE High Inc. I 8.9 Fidelity High-Inc. 8.1 IDS Extra Inc. A 8.7 Prudential High-Yield B 8.4 American High-Inc. 8.3 Fidelity Adv. High-Yield T 7.8 Northeast Investors 8.1 Average junk bond fund

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*Total return

Source: Morningstar Inc.

How Junk Yields Have Risen

Yields on corporate “junk” bonds--securities considered below investment grade--have soared in recent months as investors have grown more nervous about the economy and about financial markets in general. The yield on Merrill Lynch’s main index of U.S. junk bonds versus the yield on 10-year U.S. Treasury notes, monthly closes and latest:

Current spread: 3.89 pts.

Narrowest spread: 2.71 pts.

High-yield junk bonds: 9.30%

10-year Treasury notes: 5.41%

Sources: Merrill Lynch; Bloomberg News

Junk Fund Leaders, Laggards

Here are the best- and worst-performing high-yield bond funds, measured from the U.S. stock market’s recent peak on July 17.

TOP PERFORMERS

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Assets July 17 12-mo. Fund (millions) to Mon.* YTD* yield* Strong Short-Term High-Yield $112 +0.44% +6.23% 7.2% EquiTrust High-Yield 12 +0.39 +2.91 5.6 Legg Mason High-Yield 604 -0.23 +9.38 7.9 Pimco High-Yield A 80 -0.36 +4.87 8.0 Payden & Rygel High Inc. R 72 -0.39 +5.26 NA

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*Total return

WORST PERFORMERS

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Assets July 17 12-mo. Fund (millions) to Mon.* YTD* yield* Loomis Sayles High Yield $32 -6.95% +5.56 6.8% Salomon Bros. High-Yield A 186 -6.66 +4.25 9.5 John Hancock High-Yield A 270 -5.40 -0.11 9.6 Northstar High Total Ret. A 194 -5.30 +1.25 9.8 Dreyfus High-Yield 244 -4.45 +4.76 9.4

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*Total return

Source: Morningstar Inc.