Junk Bond Funds Reward Investors

In a time of gloom, high-yield bond funds have delivered upbeat results. During the three months ending March 5, the funds returned 5.8%, while the S&P 500 lost 21.5% of its value, according to Morningstar.

The high-yield performance is noteworthy because the funds often track stocks. High-yield funds hold bonds that are rated below investment grade. When the outlook for stocks deteriorates, prices of low-quality bonds may fall because investors worry about rising defaults.

So why did junk issues rise when stocks dipped? Junk proponents say bond prices had simply gotten too cheap as investors panicked last fall and dumped all kinds of securities.

Junk portfolio managers explain that the high yields compensate investors for the risks of default. When default risk increases, bond prices sink and yields rise. In the fall, yields skyrocketed, as investors sold bonds.

The autumn decline was the steepest recorded since Morningstar began tracking the funds in 1979. During the six months ending in November, junk funds lost 30.3%. The second-worst drop came in the last half of 1990, when the funds sank 10.2%.

As bonds suffered outsized losses last year, yields topped 20% on many issues. Since then, yields have dropped, but they remain rich. The yield on Merrill Lynch's High-Yield 100 index is 12.8%, an attractive payout at a time when 10-year Treasuries yield only 2.81%.

While the junk yields are tempting, investors should consider the risks before jumping aboard. Historically about 4% of junk bonds default every year. Lately, defaults have been running at an annual rate of 3%, but that is bound to change.

In the next year, many companies must refinance debt. Some will fail to obtain financing, and they will go belly-up. Moody's predicts that the default rate will top 15% this year, the worst showing since the 1930s. To be sure, Moody's has made plenty of mistakes lately, underestimating the problems in mortgage-backed securities. But defaults seem certain to rise.

The magnitude of the increase will determine how funds perform. If Moody's is correct about the default rate, then most funds will record losses. However, if the rate stays below 10%, then inflated yields will compensate for the capital losses caused by defaults. Top funds will stay in the black, and some may deliver double-digit results.

To profit from the rich yields, while taking only limited risk, investors should consider funds that take a cautious approach to the junk market. These funds outperformed during last year's downturn, and they seem likely to stay afloat, even if defaults rise.

For a limited taste of the high-yield markets, try Intrepid Capital Fund ( ICMBX), which Morningstar assigns to its moderate allocation category. Typical members of the category have mixes of blue-chip stocks and high-quality bonds. Intrepid takes a different approach, currently keeping 55% of assets in solid stocks and most of the rest in high-yield bonds. The formula has proved relatively successful. During the past three years, the fund has lost 1.3% annually, outdoing 96% of its peers.

A dedicated contrarian, Intrepid portfolio manager Mark Travis bought junk bonds last fall as prices dipped. "When everybody else is scared to death, we go out and acquire things," he says.

For safety, Travis is avoiding shakier issues and sticking with stable companies that are paying down their debt. He has been focusing on bonds that are rated BB+, just a notch down from BBB, the lowest investment-grade rating given by Standard & Poor's.

Besides steering away from the lowest-quality companies, Travis is shunning issues with longer maturities. When interest rates rise, long bonds can suffer big losses. To avoid interest-rate risk, Intrepid focuses on securities with maturities of two to six years.

A favorite holding is an issue from Prestige Brand Holdings ( PBH), which makes household cleaners that sell under brand names such as Comet and Spic and Span. The three-year bond yields around 10%. "We like companies that make things people need, whether that's beer, shoes or cleaning products," says Travis.

Another cautious choice is Aquila Three Peaks High-Income Fund ( ATPAX), which returned 10.6% during the past three months, outdoing 98% of high-yield funds. Seeking companies with reliable cash flows, portfolio manager Sandy Rufenacht is avoiding steel and chemical makers. Instead, he prefers companies in steady businesses, such as medical devices and supermarkets. For extra protection, Rufenacht favors fiscally prudent companies that are paying down debt and working to strengthen their balance sheets. "We like B-plus companies that are aiming to become investment grade," he says.

Rufenacht likes an issue from Constellation Brands ( STZ), the maker of Robert Mondavi wines, which should report fairly steady sales during the recession. The bonds yield 8.37%.

For a junk fund that is taking a defensive stance these days, consider T. Rowe Price High-Yield ( PRHYX). Portfolio manager Mark Vaselkiv is limiting risk, currently keeping 19% of assets in investment-grade bonds and most of the rest in issues rated BB or B, the two highest rungs of the below-investment grade market. By sticking with solid companies, the fund outperformed most competitors during the downturns last year.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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