This year might not be the best for junk bonds

Money Talk

Your Money

April 25, 2004|By MATT LUBANKO

IN A RECENT news report, I learned that mutual funds that invest in high-yield bonds delivered superior total returns in 2003. Is this trend likely to continue in 2004?

- R.Z., Wallingford, Conn.

Turning garbage into gold might not be so easy in 2004.

High-yield bonds, also known as junk bonds, have bounced upward from the abyss they fell into in October 2002.

They racked up total returns of 30 percent in 2003, the best year since 1991. And they have performed so well over the last 18 months, in part because they were so far down near the end of 2002.

The years to come might still reward high-yield bond investors with respectable returns.

Investors seeking diversification should also consider allotting 3 percent to 10 percent of their portfolios to junk bonds. But those looking for a repeat of recent junk bond history might consider looking elsewhere, said David Darst, a chief investment strategist at Morgan Stanley.

High-yield bond prices are comparatively high. Higher prices have, over the past 18 months, lowered average annual yields by as much as 7 percentage points. And debt-heavy companies refinancing at today's lower rates have depressed the yields on new high-yield bonds coming to the market.

"Right now, the supply of high-yield bonds is a bit too high, and demand isn't nearly as strong as it was," said John Fenn, a fixed-income strategist with Citigroup Inc. in New York.

This supply-demand shift is best reflected in the spreads - differences in yields - between junk bonds and high-quality government and corporate debt.

The spreads have narrowed sharply over the past 18 months.

In late 2002, junk bonds yielding 14 percent could easily be found when 10-year U.S. Treasury notes sported yields of 4 percent.

Since then, the yield spread has narrowed from roughly 10 percent to about 4 percent: today many junk bonds deliver 8 percent yields, while 10-year U.S. Treasuries yield about 4 percent.

"With less reward per unit of risk, junk bonds have become less attractive," Darst said.

But "less attractive" does not always mean "unattractive," said David Hillmeyer, co-manager of The Hartford High Yield Fund.

An improving U.S. economy has drastically lowered the default rate on high-yield debt. And default risk - the threat that a debt-heavy corporation can no longer make interest payments on its bonds - is perhaps the greatest risk faced by junk bond investors, Hillmeyer said.

But junk bonds are, almost by definition, a high-risk, high-yield investment. And when the yields shrink, as they have rapidly since late 2002, the opportunity for quick rewards shrinks, too.

I am thinking about taking a $5,000 loan from my 401(k) plan. What might happen if I were to be fired or leave the company on my own?

- C.M., Allentown, Pa.

The rules vary from company to company.

You're required to pay back the loan immediately at 71 percent of companies, according to Hewitt Associates Inc., an employee-benefits consulting company based in Chicago.

Failure to repay a loan on time could expose you to taxes and penalties.

The unpaid balance of the loan could be classified as a "deemed withdrawal" from your 401(k) plan and taxed as regular income.

The unpaid balance also could trigger a 10 percent penalty for taking that withdrawal before age 59 1/2 , said Jim Szostek, a 401(k) compliance consultant with the Hartford Financial Services Group.

Other companies, however, might allow you to make scheduled repayments on your 401(k) loan after you have to leave the company.

Which rules apply to your company? One way to know for sure is to read the terms of the borrower-lender agreement between you and your 401(k) plan, Szostek said.

Matthew Lubanko is a financial columnist for the Hartford Courant, a Tribune Publishing newspaper. E-mail him at

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