The Big Screen: Junk Bond Funds Much Less Mean Than a Junkyard Dog

Junk bond funds are taking off, but if you don't choose carefully they can live up to their name.

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Like those credit card companies that offer plastic to folks who have a sketchy financial history, junk or high-yield bond funds invest most of their money in bonds issued by young or struggling companies that get low credit ratings from agencies like Moody's or Standard & Poor's. To compensate investors for that risk, these companies issue their bonds with high interest rates or yields. So, these funds can earn solid returns and generate high income too if they study companies carefully and manage to avoid bonds issued by shops that welsh or default on their bonds. See our Investing Basics section for more background on bonds, junk bonds and junk bond funds.

Over the past three years defaults have whacked high-yield bonds and junk bond funds averaged a 1.1% annual loss over that period, according to Morningstar. But now it looks as if they were punished too harshly and are on the rebound in a big way. So far this year they're up 6.4% on average, beating every U.S. stock or bond fund category. Bond fund managers expect a solid two- or three-year recovery for junk bond funds, starting with a 20% gain in 2001.

The Year for Junk? High-yield bonds funds have put up solid numbers in Y2K1

Source: Morningstar. Returns through Feb. 8.

A 20% return sounds great and high-yield funds should be a modest part of any long-term investor's bond portfolio, so today the Big Screen is sifting through the category. For most investors the highest-flying funds are a must miss.

"The big message is that vanilla is fine," says Eric Jacobson, an associate director of fund analysis at Morningstar. "Everybody is always looking for the big winner, but if you're looking at the highest-yielding funds in the category, they got there by doing something they're not supposed to do."

Junk bond funds are risky to begin with, but some load up on unrated bonds to reach for a higher yield and draw investor dollars. Since many shops slap their own ratings on these bonds, it's not always easy to see how much risk you're taking. Jacobson's advice: Look for funds that held up best in 2000, the worst year in recent memory for high-yield funds, which lost more than 9%, on average.

So we combed through the category looking for funds that beat their average peer in 2000 and the category's recent blue period from 1997 to the end of last year, according to Morningstar. Then we yanked out funds that fell further in down months than their peers during the last three years and those that carry expense ratios above the category's 1.3% average. High expenses can take a big bite out of bond funds' returns, since they're generally lower than stock funds'. Here are the 10 funds that made the cut, ranked by their returns during last year's meltdown.

Cheap and Steady High-Yield Funds
Fund	2000 Return	3-Year Annualized Return	Yield
(STHBX Quote)Strong Short-Term High-Yield Bond	5%	6.9%	8.2%
(CMHYX Quote)Columbia High-Yield	4.6	5.2	8
(JAHYX Quote)Janus High-Yield	2.5	3.6	8.4
(PHDAX Quote)Pimco High-Yield	-0.8	3.5	8.8
(LBNDX Quote)Lord Abbett Bond-Debenture	-0.9	3.9	8.7
(VWEHX Quote)Vanguard High-Yield Corporate	-0.9	3.4	9.2
(PYHRX Quote)Payden & Rygel High Income	-1.7	3.5	9.4
(PRHYX Quote)T. Rowe Price High-Yield	-3.3	3	10.4
(OPPHX Quote)Oppenheimer High-Yield	-3.9	1.8	11.3
(AHITX Quote)American High-Income	-3.4	3.3	11.7
Avg. High Yield Fund	-9.1	-1.1	11
Source: Morningstar. Returns through Feb. 7, yield data as of most recent reports to Morningstar.

Most of these funds trail their peers so far this year, but it makes sense for those hit hardest last year to bounce highest in 2001. These funds will probably give you solid returns this year, with less risk when things get rocky down the road.

As its name suggests, the no-load (STHBX Quote)Strong Short-Term High-Yield Bond fund tends to take a bit less risk than its peers by focusing on bonds with shorter durations. Jeffrey Koch and Thomas Price run the fund, which carries a 0.80% expense ratio. Over the last three years, the fund has been far less volatile than its average peer and its 6.9% annualized return beats some 99% of its competitors, according to Morningstar. The fund is up 3.5% since Jan. 1, compared with 6.4% for its average peer.

You might be surprised to see a Janus bond fund in a Big Screen, given the Denver shop's reputation as growth fund manager, but the no-load (JAHYX Quote)Janus High-Yield fund is worth a look. Since taking the reins in 1996, manager Sandy Rufenacht has charted a risk-averse course by focusing on healthier companies that are making debt payment a priority. The fund, which carries a 1% expense ratio, averages a 9.2% annual gain over the last five years, which beats just about all its peers. Its conservative streak might hold it back a bit in a rally year like this, but its returns should still be attractive if stock funds flounder. The fund is up 4.8% so far in 2001.

You're probably not surprised to see a Pimco fund on the list, given that firm's long-standing reputation for running bond funds under the leadership of guru Bill Gross. In running the broker-sold (PHDAX Quote)Pimco High-Yield fund, Benjamin Trosky reduces risk by spreading the fund's assets broadly to avoid big bets on individual bonds or industry sectors. The fund beats more than 80% of its peers over the last one- and three-year periods and lost only 0.8% last year, compared with a 9.1% tumble for its average peer. Like the Janus High-Yield fund, it trails its peers so far this year but is still up nicely with a 4.8% gain.

Thrifty types will want to check out the no-load (VWEHX Quote)Vanguard High-Yield Corporate fund because of its tiny 0.28% expense ratio, but its record merits attention too. Earl McEvoy, of sub-adviser Wellington Management, has run this fund since 1984 with a risk-averse style. He typically holds higher-quality bonds than his peers, which has helped him post a 10.8% 10-year annualized return that beats his average peer. Since Jan. 1, the fund is up 5.2%.

Despite its similarly diversified and lower-risk style, the no-load (PRHYX Quote)T. Rowe Price High-Yield fund is up 6.8% since Jan. 1, beating its average peer during this year's rally. That doesn't mean manager Mark Yaselkiv is taking big chances, though. Since taking the fund's reins back in 1996, he's spread its money broadly around the junk market, favoring higher-quality bonds. If you're looking for proof of his prudence, consider that last year the fund lost 3.3%, less than half of what its average competitor did.

There you have it, high-yield fans, a pack of funds that will give you a piece of the action, but hopefully not too much excitement when things aren't so rosy.