High-yield bonds safer if you diversify

Dollars & Sense


With stocks in a three-year slump, investors are hunting high and low for better yield.

Many have sought safety in the bond market and are considering high-yield bonds, hungering for their hefty interest income.

As with all investments, greater return comes with higher risk.

High-yield bonds - or junk bonds, their less-kind label - have rehabilitated their reputation since they were associated with scandal in the 1980s.

And some experts say trends emanating from the bursting of the tech bubble make the bonds an attractive investment now, but within limits.

A high-yield bond is a bond that carries a Standard & Poor's credit rating of BB or lower. The rating indicates that the company or government that issues the bond has a high chance of defaulting on the debt. The high-yield bond pays the holder a higher annual interest rate, or coupon, to compensate for the steeper risk.

The average income generated from coupon payments on high-yield bonds in 2002 was 8.9 percent, according to Merrill Lynch. That can be quite tempting when money market funds are paying less than 2 percent.

"High yield is less risky than equities, but at the same time, it does not reduce risk as much as high-grade corporates or Treasuries," said Christopher Garman, chief global high-yield strategist at Merrill Lynch & Co. in New York.

Despite its riskier characteristics, high yield has a place in a fixed-income portfolio, such as a retiree's nest egg, some experts say.

Financial planners recommend that young investors carry an aggressive portfolio, heavy on stocks, then turn more to bonds and other safer investments when they near retirement.

If you follow the old formula, you should invest your age in bonds. That is to say, if you're 65, then 65 percent of your portfolio would be in bonds.

Some planners suggest slicing off a portion of this for high yield, up to one-fourth for the most aggressive portfolio. That would amount to about 10 percent of the typical 50-year-old's overall holdings.

The case for high-yield bonds has strengthened in the past two years. In the boom times of the late 1990s, the debt market was a wide-open spigot, as companies borrowed freely, often to acquire other companies at bubble-elevated prices. When the bubble burst and stocks plummeted, many companies wrote down the value of their acquisitions and were unable to get more credit. Some defaulted on their bonds - a real risk for high-yield investors.

"The high-yield market went into a cyclical blowout, because deals still got done long after they made economic sense," said Martin S. Fridson, an authority on high-yield bonds and chief executive of FridsonVision LLC in New York.

In today's more sober environment, the surviving companies that are tapping the high-yield market are doing it for a more sensible reason - to clean up their balance sheets. Many of the high-yield issues now involve companies paying off their older, higher-interest debt in favor of new debt at lower rates, much as homeowners refinance their mortgages for lower interest rates.

In 2000, managers directed nearly half of the proceeds from high-yield underwritings toward acquisitions and capital expenditures, and 28 percent to refinancing more expensive debt.

In 2002, those numbers flipped. Ten percent went to acquisitions and capital expenditures, while 55 percent went to refinancing.

For these reasons, Garman proposes that now is one of the best times in history to forgo stocks in favor of high-yield bonds.

"This directly plays to the strength of bonds and not necessarily equities," he said, "provided corporate managers really are interested in paying off their debt and not making new investments."

These trends have distanced high-yield bonds from stocks.

Usually, high-yield bonds are more closely correlated with stocks than they are with other bonds. But companies' more conservative use of high-yield issues has captured investors' attention.

Since October, much of the money that has been pulled out of the stock market has gone into high yield. "High yield has a lot going for it now," said Brent Longnecker, a former financial consultant who's president of Resources Consulting Group in Houston. "There's been an awful lot of fallout, and the really bad stuff has gone away."

So, how do you get started?

"Exposure to high yield is best achieved through a diversified mutual fund," Garman said. "A broad portfolio actually has a great risk/return profile."

But as with any investment, the devil is in the details.

Just as Wall Street welcomed the initial stock offerings of technology companies that, in retrospect, had little chance of survival, so the debt market welcomed their high-yield bond offerings.

The downturn has washed away most of the mess. But in the high-yield world, some land mines may still be buried.

"Warren Buffet says there is good junk and bad junk. Do your due diligence as an investor," Longnecker advised.

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