High current yield funds offer good return for risk Junk bond funds offer good return for high risk



Searching for high yields in a low-yield environment?

If you can tolerate the higher risks associated with high-yield investments, a well-run high current yield mutual fund may be appropriate for a portion of your portfolio.

These funds, which usually are primarily invested in corporate bonds rated below investment grade (or "junk" bonds), pay dividends of around 9 percent to 11 percent, depending partly on the credit quality of their holdings and their annual expenses. Higher yields may indicate greater concentration in issues of lower credit quality.

Lower-grade bonds pay more interest than Treasury bonds of similar maturities because of the concern that their issuers might default on interest or principal. Funds that invest in such bonds pass the premium for risk -- now around 4 percent -- along to you.

Is such premium enough to compensate you for the risk you'd take?

To help you make such a judgment, you need to look at junk bond funds in the context of their volatility in recent years.

After averaging total returns of 11 percent annually over the five years that ended in 1988, according to Lipper Analytical Services, high current yield funds had a flat year, on the average, in 1989. (Individual funds' returns ranged from plus to minus 13 percent.)

In 1990, when the recent recession began, causing worries about defaults, their average total return plunged to a negative 11.1 percent. Only five of 83 funds had positive -- but negligible -- returns. The worst performer, Dean Witter's, was off as much as 40 percent.

The junk bond market turned around in 1991 as the prospects of defaults receded, rating agencies upgraded outstanding bonds of companies with improved financial results, and companies strengthened their balance sheets by replacing debt with equity. With the Dean Witter fund leading the way as it posted a 67 percent total return, the group's average soared to 36.4 percent.

Obviously, such a pace could not continue in 1992, even if the market environment remained favorable. Thus, last year was merely a good -- not a sensational -- year as the average fund had a total return of 17.7 percent, according to Lipper. Around 10.5 percent of this was income; the rest, capital appreciation.

It was hardly a calm year, however. Returns varied from month to month but remained positive until October, when the prices of junk bonds -- and junk bond funds -- dropped suddenly. Then they rose again.

The drop was attributed in part to the consequences of sell signals issued by market timing services, influencing their clients to dump junk bond fund shares -- even though the appeal of the funds' bonds hadn't changed. The redemptions forced the funds to sell bonds.

Major no-load funds, such as those of Financial Funds, T. Rowe Price and Vanguard, were hit hard, giving up hundreds of millions in assets. Their investors weren't inhibited by redemption fees or by thoughts of paying sales loads when they wanted back in.

Because of the adverse impact of such redemptions on fund perform

ance, which penalized remaining shareholders, Vanguard in December reserved the right to impose a 1 percent redemption fee on sales of its High Yield Corporate Portfolio shares held less than a year. Financial and Price may consider similar action to discourage people who, as Price High Yield Fund portfolio manager Richard S. Swingle puts it, use his fund as a "high-yield money market fund."

All of which brings us to where we are now.

Several portfolio managers agree that their funds should be able to pay dividends of around 9 percent to 10 percent and tack on another 1 percent or 2 percent in appreciation to reflect additional increases in the prices of their bonds -- unless the economy suffers a reversal.

If you decide to consider these funds, study their strategies to find one that you can be comfortable with. They differ quite a bit.

Some, such as Merrill Lynch High Income Portfolio, which has had the group's best record for the last 10 years, have been essentially limited to "junk" bonds. Vincent T. Lathbury III, who has managed the fund for the period, tries to moderate risk by diversifying among many compa

nies. Bonds to which Standard & Poor's gave the top three of its six "junk" ratings, BB, B, and CCC, have made up most of the fund's assets. "B has been our bread and butter," Mr. Lathbury says.

"Junk" bonds tend to make up no more than 60 percent of Lord Abbett Bond-Debenture Fund. At least 20 percent must be in investment grade securities (currently Ginnie Maes). To help achieve appreciation, the rest is in convertible securities of large, high-quality companies, says Robert S. Dow, fixed income director.

On the other hand, Fidelity Capital & Income Fund, which led the category in 1992 with a 28.1 percent return (8 percent income, 20 percent appreciation), expects large capital gains by investing significantly in the debt of companies in bankruptcy or otherwise in distress. That these aren't paying dividends doesn't seem to matter.

"We're total return-oriented," says co-manager David Breazzano.

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