'Junk bonds' will look attractive as interest rates fall


September 15, 1991|By Werner Renberg | Werner Renberg,1991, Werner Renberg

As interest rates continue to slide and many forecasters project further slippage, you may be tempted to invest in high-yield bond funds, often called "junk bond" funds.

Few of the 85 high-yield funds monitored by Lipper Analytical Services still pay dividends at annual rates of 15 percent to 20 percent. But the group's recent average of 13 percent -- almost 5 percent ahead of other bond fund categories -- may have caught your eye.

You also may have noted the group's hot performance so far in 1991. Its average total return (price change plus dividends) of nearly 28 percent through August was well ahead of others.

Although this rate is unlikely to be sustained, it's hard to argue against getting another $50 annually for every $1,000 invested.

Before you rush for your phone to invest, though, consider the basics of high-yield bond funds to make sure one would be suitable for you.

As commonly defined, they primarily invest in corporate bonds rated by services such as Moody's and Standard & Poor's as being below investment grade. That is, they buy bonds of companies whose ability to pay interest and repay principal when scheduled is somewhat questionable.

In terms of Moody's nine rating symbols, such funds primarily invest in bonds assigned one of the lower five ratings, from Ba ("judged to have speculative elements") through C ("extremely poor prospects"). The higher ratings are Aaa, Aa, A, or Baa.

If issuers of bonds given low ratings are more likely to default on their obligations, why invest in them?

Because issuers of below-investment-grade bonds pay higher rates of interest to attract investors than more creditworthy companies do. Remember a basic rule of investing: the higher the risk, the higher the interest.

During the 1980s, average annual total returns for "junk bonds," as measured by the First Boston High Yield Index, ranged as high as 36.6 percent in 1982.

They plunged to 0.4 percent in 1989, when forecasts of recession triggered fears that bond issuers would default, and other factors contributed to a drop in bond prices that essentially offset interest payments.

In 1990, when the recession began, prices really slumped and the index had a negative return of 6.4 percent.

This year, however, it has roared back, rising 34.0 percent through August.

Given the risks, the prudent way to invest in such bonds is to buy a pool of them, as high-yield bond funds do.

The underlying assumption: After offsetting the probable loss caused by defaults, enough income will remain to provide a higher return than you could earn from high-quality bonds.

If you can accept the inherent risks, a high-yield bond fund might be appropriate for part of your assets -- especially for an IRA or other tax-sheltered account.

As suggested by the table, which lists top performers of the last five years, funds' performance records differ widely.

Quite a few have let their shareholders down.

Over the year that ended June 30, a period that included last autumn's plunge and 1991's recovery, 10 of 85 funds had negative returns, according to Lipper. For the last five years, as many as six of 47 funds lost money. And for the last 10 years, eight of 29 funds had lower total returns than the average money market fund (8.7 percent).

Differences in performance are due partly to differences in the levels of risk that funds accept and in the skills with which they manage it. The challenge is to find a fund that is managed to achieve high total return -- not maximum yield -- and whose riskiness you are comfortable with.

Managing a high-yield bond fund well involves a continuous stream of investment decisions, any of which can affect risk and return.

Examples: How much of the portfolio should be devoted to cash equivalents and investment-grade securities to reduce risk (while sacrificing yield)? How should holdings be divided between higher- and lower-rated "junk"? When -- and how heavily -- should the fund invest in cyclical or recession-resistant industries?

Managers of Merrill Lynch High Income Portfolio and Kemper High Yield Fund have been able to assume greater risks than some of their peers, while managing that risk well enough to lead the pack.

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