Junk funds may reward those who can take risk

MUTUAL FUNDS

December 05, 1993|By WERNER RENBERG | WERNER RENBERG,1993 By WERNER RENBERG

"My late husband bought MFS High Income Fund when it was paying 12 percent," a reader writes. "It is now down to 8 percent, and I have a feeling that it may go lower.

"I have heard of funds that are paying 10 percent to 13 percent, but the people that are talking about them won't give out names. I know nothing about investments. My husband always took care of it. Now I'm on my own, and I don't know which end is up."

If you, too, have inherited or bought shares of a "high income" fund that you don't fully understand and whose dividend checks have been shrinking, don't worry. Here's some advice to guide you.

MFS High Income is a high current yield, or "junk," bond fund. With an average 10.5 percent total return, it ranked 30th of 60 such funds tracked by Lipper Analytical Services for the last five years.

You don't need to go beyond the first page of its prospectus for a mandated statement describing its riskiness:

"Securities offering the high current income sought by the Fund (commonly known as 'junk bonds') are ordinarily in the lower rating categories of recognized rating agencies or are unrated -- and generally involve greater volatility of price and risk of principal and income than securities in the higher rating categories."

What does this mean?

* The fund invests in corporate bonds that are rated below the four investment grades -- Aaa, Aa, A, and Baa (Moody's) or AAA, AA, A, and BBB (Standard & Poor's) -- because of doubts as to whether the issuers will be able to pay interest and repay principal on time. It also may invest in issues that aren't rated but are also speculative.

* To compensate purchasers for assuming the risk that issuers may default, such securities offer higher yields than quality bonds.

* Their yields rise or fall in step with other interest rates, fattening or reducing the dividends paid by funds that own them.

* Their principal also rises or falls with changes in default prospects for junk bonds as a group or for individual issues.

The drop in yields that the reader has noticed isn't unique to the MFS fund or junk bonds. It is due to the widespread decline in interest rates, which in recent years has knocked percentage points off yields all the way up the quality ladder to U.S. Treasury bonds.

What the reader also should have noticed is a substantial rise in the value of her shares. That reflects the fund portfolio's appreciation and illustrates the importance of focusing on total return -- income plus price change -- instead of on yield when assessing the merit and suitability of any mutual fund.

Unless something unforeseen happens between now and New Year's Eve, 1993 will have been the third consecutive good year for high current yield funds. To date, the group's average total return is over 16 percent, and some funds -- such as Dean Witter High Yield, Fidelity Capital & Income, PaineWebber High Income, and T. Rowe Price High Yield -- have exceeded the average.

To be sure, the group's 5-year average return of 10.6 percent is less impressive because it also reflects the period when actual and feared defaults caused junk bond and fund prices to plunge.

Still, those results need not dissuade you from owning a well-performing high current yield fund -- provided you understand and can tolerate the risks involved.

This includes being mindful of whether funds must invest primarily or totally in the upper tiers of the junk grades (Ba/B or BB/B) or are able to invest in inferior credits, including securities which may be in default (as Fidelity Capital & Income can). A fund taking higher risks may give you higher yields, but it surely can't guarantee higher returns.

Talk to leading portfolio managers of junk bond funds, and you find agreement on at least three points:

* Funds' 1994 returns should at least be equal to their yields.

* The average quality of new issues may be a bit lower than it was in 1992 but it's higher than it was in the late 1980s.

* Improved corporate profits, which should help the stock market next year, should be good for junk bonds, too.

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