Junk Bonds Smell Sweeter Than You Might Imagine

Investing in junk bonds now may seem like buying a new car right before the model year-end clearance sale. We're in a recession, and that means default rates, which are already high, have but one direction to go -- up. So surely you'd assume that high-yield bonds must go down.

After all, these are bonds issued by companies with highly leveraged balance sheets that suffer most in a downturn. But with the yield on the Merrill Lynch High Yield Master II Index -- the best measure for the high-yield market -- back up to nearly 14%, this sector is looking very attractive again. Although I might be early by a quarter or two, I think now's a good time to, at least, take a look.

Junk had a great start in 2001. Then, like everything else, it turned into garbage. In September alone, the Merrill Lynch High Yield Master II Index lost 6.9%. Now, the index is down 1.4% for the year, still beating the S&P 500, but far short of Merrill's corporate bond index return of 10% year to date.

High-yield portfolio managers and strategists had good reason to be optimistic about 2001. In the fourth quarter of 2000, the yield on the Merrill Index reached 14% as start-up telecommunications companies with shaky business plans risked defaulting. But exceptional value never lasts long, and between Dec. 31, 2000, and Feb. 15, 2001, the Merrill Index returned 1% per week, according to a recent report by Martin Fridson, Merrill's chief high-yield strategist.

Buying high yield when times are toughest and default rates are still rising has proved to be a winning strategy, most of the time. The key question for investors is to what extent the bad news is already priced into today's market. In the last recession, bonds discounted higher default rates well before the rates themselves peaked. The way to measure that is with the yield spread: the yield on junk minus the yield on risk-free Treasuries .

In January 1991, the spread peaked at a record 974 basis points when the default rate was 11.4%. By July 1991, when default rates peaked at 13.1%, the spread had narrowed to 567 basis points. The record default rate and a record 36% return on junk bonds coincided in the same year.

The default rate is now about 9%. But Fridson told me his analysis shows that the current yield spread of 914 basis points implies that high-yield bonds are already pricing in a higher default rate of 11.75%. "What we can say is that when [the] market is valued as it is now relative to Treasuries, two-thirds of the time it outperforms -- and by enough to offset the times it underperforms. The odds are in your favor when the spread is much greater than it should be," says Fridson.

Who's at Default? The Moody's default rate is about where it was 10 years ago -- could that be good?

Source: Merrill Lynch and Moody's

The chart below tracks the performance of the Merrill Lynch Master II Index vs. the spread between 10-year Treasuries and high-yield bonds. You can see that spreads are nearly where they were in 1991 -- just before the index outperformed greatly.

Could This Junk Be About to Shine? Buying when spreads are high has been a good strategy.

Source: Merrill Lynch

Jeffrey Koch, portfolio manager of the (STHYX Quote)Strong High Yield Bond fund, says his analysis shows that high yields have never been cheaper when compared with corporate bonds and to Treasuries. Looking at corporates, for example, Koch takes the ratio of the yield on the high-yield index vs. the Lehman Brothers Aggregate Bond Index. The ratio is a record 2.7. The previous high was 1.95 set in 1990. "You can see that by valuation measures alone, absent any fundamental factors, it looks attractive," says Koch.

Koch also points out that the risky, low-quality telecom sector has diminished in importance to the overall market's performance. Of the total high-yield index, telecom now represents just 12%, nearly cut in half from its peak weighting of 22%. "And over half of that [12%] is wireless, where there isn't as much of a problem," says Koch.

Koch says he's sticking with higher-quality companies, in general, that have less vulnerability to an extended recession. His biggest exposure is in the gaming sector, where he has positioned 10% of his portfolio. The whole group traded down to very attractive valuations after the Sept. 11 terrorist attacks because of fears that travel to Las Vegas would plunge. His favorites -- and one of his largest holdings -- are the bonds of Ameristar Casinos (ASCA Quote), a regional operator with properties in the suburbs of Omaha, Neb., Kansas City, Mo., and St. Louis. Koch says Ameristar has no Vegas exposure, but the bonds are 4 to 5 points below where they were before the attack. The yield is 10.35%.

There are two ways to invest with Koch -- the Strong High Yield Bond fund and the (STHBX Quote)Strong Short-Term High Yield Bond fund. Both funds have good three-year records. If you want to grab the most upside when the high-yield market turns around, consider the Strong High Yield Bond fund -- which is down 6.7% year to date and yields 15.48%.

But if you're not convinced now's the time to jump in, the safer way to go is with the Strong Short-Term High Yield Bond fund, which has a yield to maturity of only two years, is down just 2% this year and yields 9.9%. No other fund is run with just a 1-year to 3-year maturity constraint, which is perfect if that is your investment time horizon. You won't do as well on the upside with this fund, but you'll do much better if the market weakens further.