Why Is My High-Yield Fund Sucking Wind?

On July 24, I purchased (STHYX Quote)Strong High Yield Bond because the yield was so much better than a money-market yield. Since then, the NAV has fallen a lot.

What will make this type of fund rise in price, and why is it in free fall now? Do I need to ride out this current market crisis?

-- Mike Miyajima

Mike,

Before we get into the current problem in high-yield land and the outlook for a resolution, I'm going to seize on what you said about opting for a high-yield fund because the yield was so much higher than a money-market yield and lecture you for a moment.

Based on some of the mail I get, you are not the only one in need of this lecture. Listen up, folks:

BOND FUNDS ARE NOT MONEY-MARKET FUNDS WITH HIGHER YIELDS! THE TWO ASSET CLASSES ARE IN NO WAY, SHAPE OR FORM COMPARABLE!

Money-market funds, managed to maintain a share price of $1, are cash. They're not guaranteed to maintain that share price, but for a money-market fund to "break the buck" is extremely rare. So a money-market fund is where you keep the cash portion of your portfolio, the portion you may need in the event of an emergency. A portfolio is stocks, bonds and cash, not stocks and bonds or cash.

Bond-fund shares are not cash because, as any investor in one this year can tell you, when interest rates are rising, they will probably lose value. If you needed that money for an emergency, you would be sorry.

Mike, perhaps I'm reading too much into the way you phrased your letter, but the point is: When making a decision about whether to buy a bond fund, the valid yield comparison is to other bond funds, not to money-market funds. This is not to say that comparing yields is all you should do when picking a bond investment. But if you're going to buy a high-yield fund, buy it because the yield is attractive relative to Treasury or investment-grade corporate funds, not because it's attractive relative to money-market funds.

Enough ranting.

Regarding your high-yield fund, I have good news and bad news.

It's certainly true that your fund's share price has been dropping since you bought it, as this chart shows. A couple of experts I talked to don't expect the situation to get much worse for high-yield generally. But they also don't expect it to get better anytime soon.

High-yield bonds have been suffering for at least three reasons.

First, interest rates have been rising, which isn't good for any kind of bond. But as regular readers of this column know, when interest rates are rising, riskier bonds like high-yield bonds usually outperform safer bonds. Basically, that's because the larger coupon payments (or dividends, if you buy through a fund) cushion the impact of the rising interest rates.

As you can see from the chart below, interest rates on high-yield bonds have risen more slowly than rates on safer bonds, as measured by Merrill Lynch's indices.

Rising Yields, Falling Prices The rise in yields so far this year of Merrill Lynch's Treasury, Corporate and High Yield Indices

Source: Merrill Lynch

So while most high-yield fund shares have dropped in value this year, investors are still ahead on the year, with positive total returns while Treasury and corporate bond funds have negative total returns for the year to date. Your fund, Strong High Yield Bond, has done particularly well, up 4.55% on the year through July 31, which is in the top third of retail high-yield funds tracked by Lipper.

The second trouble with high-yield bonds this year is that issuance has been strong at a time when dealers, still stinging from last fall's massive selloff, are committing much less capital to the sector, hence the falling prices. The situation is exacerbated by the approach of Y2K. Liquidity is growing in importance, and high-yield bonds aren't liquid.

Finally, even though economic growth is strong, high-yield credit quality has deteriorated and the default rate has risen, to 5.02% in July from 4.60% in June, according to Moody's Investors Service. The average default rate from 1971 to 1998 was 3.35%.

The bad news is that while experts don't see things getting much worse for the high-yield sector, they don't see them improving before the beginning of next year, either.

On the interest-rate front, Merrill Lynch chief high-yield strategist Martin Fridson says yields won't start coming down until people are convinced that the Fed is finished hiking interest rates for a while. A 50-basis-point rate hike at the Fed's next meeting Aug. 24 is probably the only thing that could accomplish that, but isn't considered likely.

On the liquidity front, Y2K is expected to continue to stand in the way of improvement in the sector. Marilyn Cohen, who manages high-yield bond portfolios as president of Envision Capital Management in Los Angeles, says the turn of the century isn't likely to instantly restore liquidity. "I never give up hope, but I don't think it's going to be a snapback," she says. "If anything, it's going to crawl back."

On the credit-quality front, Fridson notes that the economic indicator most closely correlated (inversely) to high-yield defaults, the year-on-year change in industrial production, appears to have bottomed, as the chart below shows.

The industrial sector -- really the only sector of the economy to have suffered in the past two years -- is on the rebound. But even if the economy continues to grow at a healthy clip, benefiting high-yield issuers, Fridson points out that a strong economy is "the perfect time for the Fed to crack down on asset-quality problems in the banking system," an initiative that would hurt high-yield issuers.

To make a long story short, Mike: Yes, you probably need to ride this out and hope that the new year rewards your tolerance for high risk.

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