Despite Fears, Junk Isn’t Being Trashed

When Russia, the world’s 12th-largest economy, devalued its currency in August, investors worldwide fled to safety.

Worried that Russia’s woes might trigger global recession, investors high-tailed it out of stocks and high-risk bonds--including corporate junk bonds--and headed for the relative security of U.S. Treasuries.

So there was every expectation two weeks ago when Brazil, the world’s ninth-largest economy, devalued its currency that investors would again focus on the potential for recession--and flee higher-risk securities.

But while stock markets worldwide have fallen from their recent highs, U.S. corporate junk bonds have actually risen in value so far this year, and their yields have dropped--a sign, analysts say, that this volatile but popular market sector may hold up much better in 1999 than it did in ‘98, when it took a drubbing.

Indeed, investors poured a net $1.2 billion into junk bond mutual funds between Jan. 1 and Jan. 21, putting the sector on track to attract as much as $1.7 billion this month.

If the projections hold, that would be about half the net inflows these funds saw in the five months ended Dec. 31.

Corporate junk bonds comprise a huge market of debt securities issued by companies rated less than investment grade. Because they are considered to carry higher risk, the companies are forced to pay higher yields on their bonds.

In the healthy economy of the 1990s, those higher yields have made junk bonds an extremely lucrative investment. But when Wall Street begins to smell recession--and a rising number of companies in financial trouble--many investors quickly dump junk bonds on fears that bond defaults will soar.

That’s what happened late last summer, after Russia’s collapse. So why didn’t it happen amid Brazil’s turmoil?

“It has to do with the amount of ‘liquidity’ in the market,” meaning the number of buyers willing to meet sellers, said Kathleen Gaffney, co-manager of the Loomis Sayles High-Yield fund.

Russia’s currency crisis caught many investors unprepared. That drove large banks and highly leveraged “hedge” funds to quickly unload massive positions they had taken in high-risk securities, in a wild dash to reduce exposure to possible losses.

As a result, junk bond mutual funds tanked in the third quarter, recording an average total negative return of 8%.

For the calendar year, junk funds’ average total return was a loss of 1.2%--the worst performance for the sector since 1994. A negative total return means the decline in bond principal value more than offset the yield earned.

Financial Markets Better Prepared

But this time around, financial markets seemed better prepared. At the very least, banks and hedge funds have fewer risky bets from which to flee, having already reduced their exposure after the Russian debacle.

“There’s been a credit tightening,” said Arthur Calavritinos, manager of the John Hancock High-Yield Bond fund. “If you’re a commercial bank, there’s a limit now on how much you can invest in the riskier sectors,” he said. “If you’re a hedge fund, you don’t have as much access to credit or leverage to make these bets. And if you’re a mutual fund like mine, the board of directors doesn’t want you to take undue risks.”

At the same time that fewer investors are feeling a need to lower their junk bond stakes, other investors--betting that there’s no U.S. recession on the horizon despite Brazil--have been buyers, attracted by yields still well above last summer’s lows.

As Brazil’s crisis triggered some investors to sell stocks and buy bonds, “people were saying, ‘If we’re going to buy bonds, we might as well get the highest yields, so let’s go buy junk bonds,’ ” said Martin Fridson, Merrill Lynch’s director of high-yield strategy.

The current average annualized yield on an index of junk bonds tracked by KDP Investment Advisors is 9.45%. That’s nearly 5 percentage points above the current yield on 10-year Treasury notes (4.67%).

For most of the 1990s, Merrill Lynch calculates that the typical yield “spread” between junk bonds and Treasuries was about 3.7 percentage points.

There are two ways that spread could narrow again. One way would be if Treasury yields were to rise relative to junk yields. The other would be for junk yields to fall back again. In the latter scenario, junk bonds would gain in value--boosting the potential for a strong total return, which is yield plus any capital gain.

“As the spread between high-yield bonds and U.S. Treasuries narrows, the prospect for equity-like returns increases,” noted Robert Doll, chief investment officer of Oppenheimer Funds in New York.

To be sure, few junk bond strategists expect the spread to narrow quickly in 1999. For one thing, the default rate by junk borrowers is rising, though modestly. At year-end, 3.75% of the principal amount of all junk bonds outstanding was in default, up from 3.22% in November and 2.84% in 1997.

Plus, Brazil’s woes--and the threat that other Latin American countries will also be forced to devalue their currencies, jeopardizing U.S. trade in the region--add to concerns over default risks. Indeed, if the world does slide into recession, it’s almost certain that the entire high-yield bond sector will be slammed.

Still, Jerry Paul, manager of the Invesco High-Yield fund, thinks junk yields could come down enough to narrow the spread versus Treasuries to 4 percentage points.

For one thing, the news from Brazil could cause a slowdown in the new issuance of high-yield debt, Paul said, as investors become choosier about financing companies. In an ironic way, then, Brazil’s devaluation could help--rather than hurt--the junk bond market by bringing supply down closer to where demand is.

Performance Could Vary Significantly

Even so, investors who are either thinking about a junk bond mutual fund investment or evaluating a fund they currently own should realize that performance could vary significantly this year.

To identify junk bond funds with good prospects in 1999, The Times studied Morningstar’s universe of 218 funds that are open to retail investors.

First, we threw out all funds that haven’t beaten at least two-thirds of their peers over the past one and three years. Next, we eliminated all funds that had more than 20% of their holdings in bonds that are either non-rated or rated lower than “B” (junk bonds are all issues rated lower than “BBB”) by major credit-rating agencies.

Why remove funds with significant holdings in the lowest-quality bonds?

“This is very much a two-tiered market right now,” said Calavritinos of the Hancock High-Yield fund. Because investors have yet to return to the riskiest (and therefore highest yielding) end of the junk bond universe, following last year’s market turmoil, “anything below single-B is really still hurting,” he said.

Adds Louise Rieke, manager of the United High-Income funds: “If there’s any question of credit quality in this environment, the mainline high-yield people don’t want to own it.”

She, like many other junk fund managers, believes higher-quality B- and BB-rated bonds are likely to continue to outperform lower-quality issues, as they did in the latter half of 1998.

This screen left us with nine funds. We then added one more: Pimco High-Yield. The retail shares of this fund were originally screened out because they lacked a three-year record. But if you consider the institutional share class of this fund, Pimco High-Yield has managed to beat at least 94% of all junk funds over the past one, three and five years while maintaining an average credit quality of BB.

Here, alphabetically, is a look at the funds that met our criteria:

* Columbia High-Yield (no load; minimum initial investment: $1,000; [800] 547-1707). Manager Jeffrey Rippey turns his back on bonds that aren’t rated at least B, and nearly 45% of the portfolio is in securities rated BB.

Morningstar’s proprietary risk-scoring system considers this fund 43% less risky than other junk bond funds, yet the fund’s three-year average annual total return of 9.3% beats the average junk fund’s return of 7.8%.

* Federated High-Income Bond A (4.5% load; $500; [800] 341-7400). Manager Mark Durbiano not only considers a bond’s credit quality, he focuses closely on the prices of individual bonds relative to others, passing over issues that he believes are overvalued.

* First Investors Fund for Income A (6.25% load; $1,000; [800] 423-4026). Morningstar considers this $410-million fund 33% less risky than its peers. Yet it finished in the top 84% of all junk funds over the past one, three and five years. Still, investors should note that this fund’s front-end load of 6.25% is high. Ditto for its cousin, listed next.

* First Investors High-Yield A (6.25% load; $1,000; [800] 423-4026). Though less than 7% of this $196-million portfolio was recently invested in the lowest-quality (and therefore highest-yielding) junk bonds, it still finished among the top 90% of its peers in terms of total return over the past five years.

* Lord Abbett Bond-Debenture A (4.75% load; $1,000; [800] 874-3733). By prospectus, this $2.3-billion fund must invest at least 20% of its assets in investment-grade bonds, which can act as a buffer for the majority junk portion of the portfolio. Investing more cautiously today, however, manager Christopher Towle currently has more than 25% of the fund in high-quality debt.

* Pimco High-Yield A (4.5% load; $250; [800] 426-0107). Despite manager Ben Trosky’s play-it-safe approach--recently, 50% of the fund was in BB-rated debt and 10% was in investment-grade bonds--this fund still beat more than 97% of its peers in 1998.

* T. Rowe Price High-Yield (no load; $2,500; [800] 638-5660). Historically, this $1.7-billion fund has been willing to take on more credit risk than many of its peers, owning more lower-quality corporate issues. But last year, manager Mark Vaselkiv began raising his stake in higher-quality junk bonds. Most recently, BB-rated bonds constituted 22% of the fund.

* United High-Income A (5.75% load; $500; [800] 366-5465). “What we try to do is find those companies that are on the verge of being upgraded, from B to BB, or from BB to [investment-grade status],” says manager Rieke. Recently, that has led her to bonds of various telecom firms, many of which, she says, “have the potential of being [acquired] by investment-grade companies.”

* United High-Income II A (5.75% load; $500; [800] 366-5465). Rieke runs this fund with the same basic philosophy as the aforementioned fund, although this portfolio recently has maintained slightly higher credit quality overall.

* Vanguard High-Yield Corporate (no load; $3,000; [800] 662-7447). Manager Earl McEvoy sticks with bonds rated B or BB as well as those issued by companies with strong cash flows.

*

Times staff writer Paul J. Lim’s e-mail address is paul.lim@latimes.com.

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Junk Yields Pull Back

Yields on high-risk U.S. corporate junk bonds surged late last summer amid global financial turmoil. But despite Brazil’s financial woes in recent weeks, junk yields have continued to ease back from their October peaks as investors have reentered the market. The average yield on an index of 100 junk bonds tracked by KDP Investment Advisors, monthly closes and latest: Monday, 9.45%.

Source: Bloomberg News

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High Return, Less Risk

These corporate “junk” bond funds finished at the top of a Times screen of Morningstar’s junk fund universe. The screen searched for funds that have beaten the category average over the last year and last three years, measured by “total return,” which is interest earnings plus or minus any change in principal value. The screen also eliminated those funds that recently had more than one-fifth of their holdings in the riskiest (i.e. lowest-rated) junk bonds. One- and three-year (annualized) returns are shown, as well as each fund’s most recent 12-month yield.

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1-year 3-year total tot. ret. 12-month Fund name return (annualized) yield Columbia High-Yield 5.6% 9.3% 7.7% Pimco High-Yield 5.6 10.1 8.2 Vanguard High-Yield Corporate 5.1 9.1 8.5 Lord Abbett Bond-Debenture A 4.1 9.4 8.0 T. Rowe Price High-Yield 3.9 10.1 9.1 United High-Income A 3.4 9.9 8.5 First Investors Fund for Income A 2.0 9.2 9.9 Federated High-Income Bond A 1.8 9.5 9.0 United High-Income II A 1.6 9.4 8.8 First Investors High-Yield A 1.4 8.7 9.4 Average high-yield bond fund -1.4 7.8 9.3

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Note: Return figures are through Jan. 22.

Source: Morningstar Inc.