Five Winning Funds: This Junk Belongs in Your Trunk

Looking to tap the hot high-yield market? These funds have delivered.
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Investors are starting to like a little more junk in their trunk.

The high-yield, or junk, bond fund category has been consistently hot since the market starting climbing off its early-October lows. Since the start of the fourth quarter of 2002, high-yield funds have surged 16.12% on average and are on pace to post a sixth straight monthly gain in April, according to Lipper, a Reuters Company.

As would be expected, the money follows performance: More than $10 billion flew into junk bonds during the first quarter, tops among all fund categories, Lipper said. While the junk sector may cool from its torrid pace and performance-chasing isn't an advisable course, 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 fixed-income arena. This week's

Five Winning Funds

offers a few worthy candidates.

But first, let's go over 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 -- 2002 witnessed a record $170 billion in junk bond defaults, according to Moody's, which projects the default rate will ease 7% this year. Indeed, thanks to an improving economy, the default rate for the past 12 months fell to 6.9%, compared with 10.7% default rate in January 2002, according to Moody's.

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. Last fall, junk bond woes 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%.

That yield spread has narrowed to about 700 basis points, meaning junk bonds pay about more percentage points more then 10-year Treasury notes' 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 Winning Funds

for the Junk Bond Fund category:

1. Vanguard High-Yield Corporate

If you're looking for the safest and cheapest way to invest in junk bonds, the $8.25 billion

(VWEHX) - Get Report

Vanguard High-Yield Corporate (Ticker: VWEHX) is for you. While the fund counts

Tyco

(TYC)

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 3.22% -- in the top 12% of all junk bond funds for the period -- and a 10-year annualized return of 6.42% -- in the top 9%, according to Morningstar.

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. Northeast Investors

At the riskier end of the high-yield bond fund spectrum is the

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Northeast Investors fund (Ticker: NTHEX), 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 6.67%, putting it in the top 6% 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.

For more about this fund, check out

this recent 10 Questions interview with co-manager Bruce Monrad.

3. Janus High Yield

Yep, 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 $879 million-in-assets

(JAHYX) - Get Report

Janus High Yield fund (Ticker: JAHYX) gets high praise for its impressive performance in good and bad times.

Sandy R. Rufenacht has managed the fund since July 1996, notching a 3.51% five-year average annual return -- placing it among the top 9% of its peers, according to Morningstar. Janus High Yield has taken on sizable bets in the debt of tech outfits such as

Apple

(AAPL) - Get Report

and

EchoStar

(DISH) - Get Report

, 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. 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 $2.72 billion

(PRHYX) - Get Report

T. Rowe Price High Yield fund (Ticker: PRHYX) has a 10-year average annual return of 6.41%, and its one, three-, five- and 10-year returns are all among the top 15% of the category, according to Morningstar. The fund holds "safer" credit, such as cell-phone giant

Nextel

(NXTL)

, so it's less likely to be the victim of several blowups. It is also the most diversified fund on the Five Winning Funds lot: It holds more than 300 bond offerings, with none of them making up more than 1.2% of the fund.

5. Buffalo High Yield

With $141 million in assets, the

(BUFHX) - Get Report

Buffalo High Yield fund (Ticker: BUFHX) is the smallest of the

Five Winning 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 3.43% ranks it in the top 10%.

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

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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.