Junk bonds may be safer than the name suggests

Investing

August 12, 1996|By Bill Atkinson

THE LAST PLACE anyone might think of as a safe haven for their money is the junk bond market.

Remember junk bonds? They were the securities embraced by Michael Milken, who used them to finance scores of corporate takeovers in the 1980s. They ended up crippling companies under crushing debt and forcing layoffs and failures.

But stack up the performance of junk bonds against corporate bonds and the results are eye-opening. Junk bonds, also known as high-yield bonds, have consistently beaten corporate bond funds on an annualized basis over the past 10 years.

In 1995, for instance, 151 junk bond funds had a cumulative 16.37 percent return, compared with 15.63 percent for 642 corporate bond funds, according to Morningstar Inc., a Chicago-based research and publishing firm that tracks the mutual fund industry.

And for the first half of this year, junk bonds had a total return of 4.81 percent, compared with a negative 0.90 percent for corporate bond funds.

"This has been the year to own the Kmarts of the world," said Mark Wright, a Morningstar analyst, who follows the junk bond market.

Unlike the highest-rated bonds, which are rated AAA, junk bonds are speculative because it's unclear if the issuer has the ability to pay interest and repay principal. They are issued by companies heavy with debt and pay higher yields because of the risk.

A junk bond rated "BB" indicates the lowest degree of speculation, while one rated "CC" is the highest degree of speculation.

Investors should have at least 5 to 10 percent of their portfolio in junk bonds, experts say.

"They offer good diversification from stocks," Wright said. "They have a high expected rate of return over the long haul. I think they are ideal for long-term investors. When I look at my portfolio, I want to try to own as many different types of assets that will behave differently."

But junk bonds carry plenty of baggage. Their name alone doesn't inspire confidence.

"People tend to think those are very high-risk investments, but only about 3 percent of junk bonds per year go unpaid or the companies go belly up and file for bankruptcy," said Tom Byrne, director of research with Individual Investor Group, a financial publishing and money management firm based in New York. "On that level, there is a huge misinterpretation. They are probably not as risky as most people think."

Junk bonds are frequently associated with reckless practices of the 1980s, when billions of dollars were raised to finance the acquisition of companies that weren't creditworthy.

The practice often ended in disaster for thousands of employees who were fired after debt-laden companies were either forced into bankruptcy or forced to sell off huge pieces of the business.

Many of these deals were masterminded by "junk bond king" Milken, who ended up spending time in prison for violating securities laws.

"It is still a controversial investment," said Mark Vaselkiv, president of T. Rowe Price High Yield Fund, and executive vice president of T. Rowe Price Corporate Income Fund.

"But we enjoy explaining to people that it is not poison like you think it is. I think they [junk bonds] really surprise people, not only in the returns, but in the lower volatility as well."

Unlike bonds, which perform well when the economy is gloomy, junk bonds perform well when the economy is healthy. And they are less volatile than bonds, which move up and down on interest rates. Junk bonds fluctuate on credit risk and the strength of the economy.

"If you make the wrong call on interest rates you get smoked," Vaselkiv said. "If the economy is accelerating, that means higher corporate earnings, which means improved credit quality."

The best way to invest in junk bonds is through mutual funds, which offer variety and a cheaper way to get into the high-yield market.

But investors should pay attention to the fund's five-year track record and whether the mutual fund's management has been stable, experts say.

Some top-performing junk bond funds include Janus High Yield, which was up 13.96 percent in the first half of this year; Strong High Yield Bond, up 13.89 percent; and Touchstone Income Opportunity A Shares, up 11.58 percent.

Price's Vaselkiv runs a fund with $1.2 billion in assets under management, and he invests in high-quality junk bonds rated "BB" and "B".

"What we try to do is take a value approach and find companies that are temporarily out of favor and buy them cheap," he said.

The fund typically will buy $12 million to $20 million in junk bonds if it likes the company.

"We don't want to take huge bets," Vaselkiv said. "You have to pay attention to risk control. If you don't, you can really get hammered." He and other junk bond fund managers were hammered in 1989 and 1990 when the high-yield market tanked.

He was faced with enormous redemptions as assets under management fell to $450 million from more than $1 billion.

"I was putting my resume together at that point thinking about new alternatives," Vaselkiv said.

But the junk bond market has been holding up quite well, thanks in part to a healthy economy.

"The downside is clearly if we go into a recession," Vaselkiv said. "A lot of my portfolio will be affected. But it looks to me like corporate earnings are strong. This is the ideal environment for junk bonds."

Pub Date: 8/12/96

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