Time might be right for a hunk of 'junk'
Amid all the turmoil in the multitrillion dollar US bond market - stirred up by well-publicized bankruptcies such as Enron, Kmart Corp., and Global Crossing - there is one unexpected sea of semi-tranquility: the junk-bond market.
Yes, junk bonds - officially "high yield" bonds - look poised for solid returns during 2002, experts say, especially during the second half of the year.
"This is a good time to put money into a high-yield bond fund," says Louise Rieke, portfolio manager of the Waddell & Reed Advisors High Income Fund, in Overland Park, Kan. "Not all your money," she cautions, "but perhaps 10 percent or so - though not more than 25 percent."
Her fund was up about 7 percent for the 10-year period through Jan. 31, 2002.
But in the case of junk issues, remember, it's "buyer beware." Junk bonds are noninvestment-grade securities issued by companies that tend to be mired in debt.
Where high-quality corporate bonds carry letter ratings with As and Bs (AAA to BBB by Standard & Poor's, for example), junk bonds are in the low Bs to Cs (BB to C by Standard & Poor's).
The entire junk-bond market is estimated to be between $650 billion and $700 billion dollars, with current yields running about 12 percent. That compares to yields of under 2 percent to 5 percent for alternative fixed-income products, including money-market accounts, bank certificates of deposit, and US Treasury bonds.
The downside, of course, is market risk: Yields are sky high on junk-bond products precisely because issuers need to attract investors. Defaults were high last year, running about 10 percent of the overall market. (In January of 2002 alone, according to Standard & Poor's, some 41 companies around the globe defaulted on their junk-bond issues.)
Still, a number of brokerage houses and investment specialists are now touting high-yield bond products.
"We see good returns for high-yield bonds for the next two to three years" with the potential for double-digit returns, says Steve Savage, editor of the No-Load Fund Analyst, a market newsletter in Orinda, Calif.
"A rebounding economy is almost always a plus for the junk-bond market," adds Scott Berry, who tracks fixed-income products for financial-information firm Morningstar Inc. in Chicago. Default rates for companies issuing junk bonds tend to lessen as the economy expands, and "endangered" companies watch their cash flow and sales rise.
For most small investors, mutual funds have traditionally been a relatively safe haven when buying junk bonds. The funds have grown increasingly popular since the late 1980s.
"Junk," it should be remembered, is a fairly recent investment concept, going back to the heady days of the 1980s, when financial wizard Michael Millken turned brokerage house Drexel Burnham Lambert into the high-yield bond leader of Wall Street.
Mr. Millken's concept was simple, yet brillant: The risk of less creditworthy bonds, he had surmised, was offset by their higher yields.
Alas, the junk-bond market dissolved into scandal by the end of the decade, as more and more issuers went bankrupt. Millken was sent to prison, and Drexel Burnham Lambert ceased to exist.
But by the mid-1990s, the junk-bond market was once again flourishing. Morningstar now counts at least 384 high-yield funds.
Last year junk-bond funds cranked out returns of about 2 percent. But that still beat the overall US equities market, which was in the red.
Junk-bond funds, precisely because they buy so many diverse types of securities, tend to be all over the scoreboard. Last year, for example, Pioneer High Yield Fund was up a whopping 17 percent; Federated International High Income produced a 13 percent return; Buffalo High Yield, an 11 percent return. But a number of the funds posted dismal losses.
Ms. Rieke, of Waddell & Reed, looks for slightly better-quality offerings among the junk-bond universe, eyeing firms that are closer to investment-grade quality. She also keeps a fairly sizeable cash position for her fund, currently about 10 percent. Bond sectors she likes include healthcare, cable television, and gaming.
Ed Han, manager of the Transamerica Premier High Yield Bond Fund, in San Francisco, believes some of the luster is now off the healthcare sector. "I like energy (both electricity and gas), paper firms, and capital-goods producers," all of which tend to post gains in a recovering economy, he says.
While acknowledging the current volatility within US debt markets, Mr. Han does not believe that the high-yield market should be unduly affected. His outlook: The economic recovery, which he believes is under way, will carry the day for high-yield products in 2002.