Editor's note: This is the first installment of a weekly series, Five Funds, which offers solid mutual fund picks in a specific category. This week's focus: high-yield bond funds.
After a few years in the doldrums, junk bonds during the past three months lived up to their more sanguine moniker: high-yield.
The average high-yield bond fund has returned an impressive 9.6% during the past three months, according to Morningstar. While that torrid pace (this is the bond world, folks) is likely to ease a bit in 2003, fixed-income strategists and money managers -- including skippers at Pimco, T. Rowe Price and Oppenheimer -- have recently sung the praises of the junk bond market, saying it looks like the strongest component of the cooling fixed-income arena. And so it goes, cash has poured in to the sector: High-yield corporate bond funds reported $1.0 billion in inflows for the week ended Wednesday, the largest level since Nov. 6, according to AMG Data Services.
With more money likely to flow into the category, we thought it appropriate to kick off our
series with stellar offerings from the junk bond fund world.
But first, a quick background and a few kernels of advice on the junk bonds and junk bond funds. Corporate junk bonds are below investment-grade bonds as rated by agencies like Standard & Poor's and Moody's (below BBB- and Baa3, respectively). The downside with junk bonds is the risk of default -- last year witnessed a record $170 billion in junk bond defaults, according to Moody's, which projects the default rate will ease 7% this year.
With Funds, What You Don't Know Can Cost You
G. Paul Matthews Sees Riches in Asian Funds
In exchange for the risk of investing in troubled or speculative companies in the junk bond arena, investors get the potential for greater rewards in the form of higher rates of return. Junk bond woes recently pushed the spread between junk bonds and Treasuries to north of 1,000 basis points, or 10 percentage points. In other words, junk bonds might pay 10% more than the benchmark 10-year Treasury's 4%.
"Even with the recent runup, there are better opportunities here, given the yield spreads," said Scott Berry, bond fund analyst at Morningstar.
Since investing in individual bonds often requires a minimum of $5,000 or more, the easiest way for individuals to tap into the market is junk bond funds. "Unless you have in excess of $100 million, you should get into junk bonds via a fund," says Harold Evensky, a financial planner and principal with Evensky Brown & Katz in Coral Gables, Fla.
These funds offer diversity -- you wouldn't have wanted to own only WorldCom junk. Given that they are somewhat of a specialty asset class and carry additional risks if the economic recovery falters, Evensky and other financial planners suggest investors who want to buy into junk bond funds should keep them to about 5% to 10% of their total portfolio.
When searching for a good high-yield bond fund, investors need to pay special attention to three key areas:
Manager tenure: It's important to have a long-tenured manager who has been through a cycle or two and knows how to ride the high and low times, since the sector has plenty of both.
Appropriate risk: A junk bond fund carries risks, of course, but funds that are loaded to the gills with unrated bonds or bonds rated below B often spell more volatility and more trouble. Investors can determine a fund's level of extra-risky debt by checking out the fund firm's Web site or checking Morningstar's site.
Expenses: "The underlying credit research tends to make these funds more expense, but investors need to keep an eye on the bottom line," Berry says.
Without further ado, here are the Five Funds for the Junk Bond Fund category:
1. (VWEHX) - Get Vanguard High-Yield Corporate Inv Report Vanguard High-Yield Corporate
If you're looking for the safest and cheapest way to invest in junk bonds, this $7.1 billion Vanguard offering is for you. While the fund counts
debt among its top 15 holdings, it holds less than 1% of its assets in the telecom sector and a mere 0.5% of assets in below-B-rated credit, according to Vanguard's Web site.
Investors are also getting a steady hand at the helm. Earl McEvoy, a portfolio manager with the fund's subadviser Wellington Management, has managed Vanguard High-Yield Corporate fund since 1984. Under McEvoy, the fund has posted a five-year annualized return of 2.42% -- in the top 9% of all junk bond funds for the period -- and a 10-year annualized return of 6.67% -- in the top 10%.
What else could you want in a fund? How about a minuscule 0.27% expense ratio -- compared with 1.29% category average. "With this fund, you start with a one-percentage point advantage on the competition," Berry says.
2. (NTHEX) - Get Northeast Investors Trust Report Northeast Investors
At the riskier end of the high-yield bond fund spectrum is the Northeast Investors fund, which has 32.9% of its assets in sub-B-rated and unrated debt. This more-aggressive stance has hindered performance a bit during the past few years, but over the long haul the fund's performance is beyond reproach. Northeast Investors' 10-year average annual return is 7.48%, putting it in the top 2% of its peers, according to Morningstar.
Also working in the $1.7 billion fund's favor is its tenured management -- father and son Ernest Monrad and Bruce Monrad have been managing the fund for a combined 55-plus years. They have also managed to keep costs down: The fund's 0.65% expense ratio is half its category average.
3. (JAHYX) - Get Janus Henderson High Yield T Report Janus High Yield
You heard me.
The Denver fund shop doesn't find many of its growth-stock funds turning up on recommended lists these days, but its $668 million-in-assets high-yield fund gets high praise for its impressive performance in good and bad times.
Sandy R. Rufenacht has managed the fund since July 1996, notching a 3.2% five-year average annual return -- placing it among the top 5% of its peers, according to Morningstar. Janus High Yield has taken on sizable bets in the debt of tech outfits such as
, but that doesn't mean it carries higher risk. The fund has only 3% of its assets in sub-B-rated credit. Also, Rufenacht has kept a lid on expenses, which tally 0.99%.
4. (PRHYX) - Get T. Rowe Price High Yield Fd Report T. Rowe Price High Yield
Mark Vaselkiv has run this fund with a sure hand since 1996. While the fund isn't likely to trounce the competitions during a heady bull run for junk, the slow and steady approach has been a winning formula over the long haul.
The $2.3 billion T. Rowe Price High Yield has a 10-year average annual return of 6.68%, and its three-, five- and 10-year returns are all among the top 8% of the category, according to Morningstar. The fund holds "safer" credit, such as cell-phone giant
, so it's less likely to be the victim of several blowups. It is also the most diversified fund on the Five Fund lot: It holds more than 300 bond offerings, with none of them making up more than 1.2% of the fund.
5. (BUFHX) - Get Buffalo High Yield Investor Report Buffalo High Yield
With $111 million in assets, the Buffalo High-Yield fund is the smallest of the Five Funds and the only one that can be considered as something of an undiscovered gem. If you haven't heard of the fund, here's a good place to start: The fund's 6.62% three-year average return places it in the top 3% of all high-yield offerings, and its five-year return of 3.25% ranks it in the top 4%.
Kent Gasaway has managed the fund since its May 1995 inception, taking on David Eshnaur as a co-manager in 2000. Gasaway's fund tends to make some concentrated bets in particular sectors and stocks among its 87 bond holdings, which led the fund to trailing four-fifths of its peers in 1998 and 1999. However, his bets on long-term consumer trends -- with sizable portions of
Barnes & Noble
and plenty of gaming-sector stocks -- has paid off extraordinarily well during the past three years.
The fund's expense ratio comes in at 1.04%, a tad higher than the others on the list but still well below the category average.