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Junk-Bond Funds Face Growing Risk of Telecom and Tech Defaults

Ian McDonald

Last year's TMT love-fest has hit junk bond funds as hard as tech funds.

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Over the past few years, investors fell in love with little companies in the technology, media and telecommunications sectors. This year, some of these companies, particularly in telecom, have hit the skids, sending tech and telecom funds down more than 15% since Jan. 1, according to Morningstar.

But high-yield bond funds -- which often feed on low-rated, or junk, bonds issued by fledgling firms -- have taken a hit, too. Some companies have defaulted on their bonds, which are essentially IOUs the company writes to banks and investors who loan it money. (For more on the basics of stocks and bonds, check out TheStreet.com's Basics section.)

The upshot: So many shaky TMT companies got money so easily in the IPO market over the last few years that many of them were able to issue bonds that they'll have a tough time paying back -- leaving many high-yield bond fund investors holding the New Economy bag. And given the sector's evaporating liquidity, they may be holding that bag for a while.

"Quite a few funds have had trouble," says Scott Berry, a Morningstar analyst who focuses on bond funds. "The problem has mostly been defaults in telecom. A lot of these issues came out a few years ago and they shouldn't have happened."

Investors typically buy high-yield bond funds for some diversification away from the stock market, with a healthy dab of income and volatility along the way. They might be getting more volatility than they imagined.

The average high-yield bond fund is down just shy of 7% since Jan. 1. Only 14 of the some 130 junk-bond funds out there are in positive territory since Jan. 1. Indeed, high-yield bond funds are the worst-performing bond fund category this year. Berry says the companies whose bonds have hurt funds the most are Interact Systems, Viatel (VYTL Quote) and GST Telecommunications(GSTXQ Quote).

In looking at the leading and lagging high-yield funds it seems that managers who took a risky path paid a steep price. The bottom five funds, on average, have more than 80% of their assets invested in bonds rated B or below, while the top five funds, on average, invested some 58% of their assets there.

The losses have been compounded by consolidation among big bond brokers.

"In the old days when you wanted to bail out of a bad credit, you'd call all the brokers and sell a little piece to each. Now, through consolidation, you have fewer places to sell that debt," says Barry Evans, chief fixed-income officer at Boston-based John Hancock Funds. "And when [bond] prices start to go down, they are all less interested anyway. So we have a liquidity problem that compounds things."

This year's blowup comes on the heels of three tough years for the category. High-yield funds are averaging a 1.2% loss over the last three years, according to Morningstar.

"The troubling thing is that the last three years haven't been good. People have typically been taught that high-yield funds do well when the economy does well," says Berry.

Diminishing Returns? Recent yearly returns for high-yield bond funds

Source: Morningstar. Performance figures through Nov. 14.

Hancock's Evans blames the last three years' disappointments on "a confluence of events," like the Asian crisis of 1998 and the Fed's interest-rate increases.

It's tough to blame junk-fund managers for having exposure to these sagging bonds because they're a big part of the high-yield indexes -- the yardsticks for their funds' performance. Evans says TMT bonds make up some 40% of the Merrill Lynch High-Yield Masters Index, for instance.

Of course, high-yield fund investors probably don't see that as a solace. Morningstar's Berry says investors should typically avoid high-yield funds that invest an above-average percentage of their assets to bonds rated below B or not rated at all -- the average high-yield fund has 15% of its assets there.

Some of the best high-yield funds come from fund shops known for their acumen at picking tech and telecommunications stocks, because this research works for stock and bond investors alike. Berry highlights the no-load (JAHYX Quote)Janus High-Yield fund, up 2.3% since Jan. 1. That said, he sees more bond defaults and rougher seas for high-yield funds ahead.

For most investors seeking a safe harbor in which to diversify their stock portfolios, a less-risky bond fund probably makes the most sense. One solid option is the broad and cheap (VBMFX Quote)Vanguard Total Bond Market Index.