You just can't trust a name anymore. Like ``junk.'' In the bond business, junk usually refers to corporate bonds that haven't earned one of the top four grades from Moody's or Standard & Poor's, the major rating services. More recently, the name has been applied to bonds issued to help finance corporate takeovers. Because these bonds usually aren't rated at all, they get the junk name, too.
To attract investors, companies issuing these bonds have to pay bigger yields than more highly rated bonds. That's why the so-called junk bonds are more charitably called ``high yield'' bonds.
The mutual funds that invest in these bonds are currently paying a little better that 12 percent yields, which can be pretty attractive to someone who hasn't been able to get better than 6 or 7 percent from a money market fund, or 9 percent from a fund investing in higher-rated bonds.
Part of the reason so-called junk bonds pay higher yields is that they're supposed to be more risky. But a recent study found that, in mutual funds at least, the risk just may not be there. That doesn't mean investors should consider them totally risk-free, however.
Mutual Fund Values, a publication that follows and rates mutual funds, came up with a list of bond funds with the lowest risk. Many of those funds were of the high-yield variety. One out of 4 of the 25 least risky bond funds invests primarily in securities rated B or under. The only group with a similar low-risk profile was short-term bond funds, but the yields were correspondingly lower, too.
``We measured the funds' returns relative to the return on Treasury bills,'' said Don Phillips, editor of Mutual Fund Values. ``We did it over a 10-year, 5-year, and 3-year period.'' Those funds that did the best job of holding their yields over those periods were judged least risky, Mr. Phillips said.
(Mutual Fund Values, which evaluates funds much the way Value Line looks at corporate stocks, is available for $295 a year from Morningstar Inc., 295 West Jackson Blvd., Chicago, IL 60604.)
While an individual attempting to buy one or a few high-yield bond funds for his own portfolio might be undertaking a great deal of risk, the combination of wide diversification and full-time, professional portfolio management minimizes the risk, Phillips added.
The T.Rowe Price High Yield Fund, for instance, has its assets in 146 issues from 51 industries, spokesman Steven Norwitz says.
But all this should not be taken to mean there is no risk.
``If you define risk as low volatility relative to other bond funds, then these high-yield funds will appear to be less risky,'' says Michael Lipper, president of Lipper Analytical Services in New York. But compared with other investments, he adds, high-yield funds have the potential to be much more risky, particularly if the economy enters a sudden recession. Before that happens, you need to understand the risks.
Currently, Mr. Lipper says, high-yield funds are paying an average yield of about 12.1 percent. That compares with about 9 percent for a fund that buys bonds rated A or better (double-A and triple-A are the highest ratings). ``That 310-basis-point [3.1 percent] spread is just about right,'' Lipper says. ``The default rate on these bonds has been between 1 and 2 percent. You need a little additional cushion, because the quality of some of this paper is less than it should be.''
Many of the high-yield bonds in funds' portfolios, Lipper says, were used to finance leveraged buyouts (LBOs), in which a company is taken private or bought by its employees. A quick recession would make it hard for these companies to pay off their bonds.
``If the recession is five years out, these companies will have grown and will have paid off some of that debt,'' he says. ``But if the recession happens quickly, then you'll have some problems, because these companies have a lot of debt relative to their assets. Many LBOs were put together based on selling some assets. But this takes time. If there's a recession, you can't do it.''
Other analysts note that high-yield bonds - and the funds that invest in them - have performed well precisely because the United States has seen several years of expansion, which investors should probably not expect to continue.
``We've had an economic expansion since November of 1982,'' says James Grant, publisher of Grant's Interest Rate Observer, a newsletter in New York. ``If we have a recession, many of these bonds will go into default.''
Should that occur, high-yield bond funds can be expected to act like all bond funds, that is, their yields will climb sharply, but the prices of the bonds in the portfolios will fall even more rapidly, more than wiping out any gains from the higher yields, and the net asset value, or share price of the fund, will fall.
``And what happens if all financial assets are overvalued?'' Mr. Grant asks. ``Historical rates of return may be irrelevant.''