Junk Bonds: Pick 'Em When They're Down
The latest market turmoil has taken a heavy toll on the $700 billion high-yield sector, but the trashing of junk bonds is nothing new. Low-grade corporate debt has been in a funk for three years, and the average junk bond trades for less than 81 cents on the dollar. Total returns on high-yield bond funds have lagged those of near-riskless money-market funds. That's because while junk funds were making large payouts, their portfolio values were melting away. About the only thing on the way up are bond defaults (chart). "We've never had such a long, dry spell of poor performance," says Margaret Patel, manager of the $120 million Pioneer High Yield Fund. "But it's always darkest before the dawn."
Indeed, signs in this distressed sector point to better returns ahead. True, the default rate on high-yield bonds is 3.83%, up from less than 1% in 1997, and defaults continue to grab headlines. Optical telecom company Linc.net recently shelved its $175 million junk bond sale citing a lack of investor demand. Upstart local phone company GST Telecommunications' $3.2 billion default announced last May and difficulties at ICG Communications (GSTXQ), which owes creditors more than $2 billion, have only added to the jitters.
Yet to wait for a clear reversal of fortune could mean a big opportunity missed. In 1991, junk bonds rallied well before defaults peaked. "I can't tell you when this pain ends, but sometimes you need a bit of a contrarian mentality to pull the trigger on investing," says Thomas Soviero, manager of the $3.3 billion Fidelity Advisor High Yield Fund.
RIGHT TIME? Investors who enter now are being well compensated. Junk-bond prices have gone so low that the yields are about eight percentage points higher than comparable Treasury bonds. This spread is called the "risk premium." It's not as high as it was in December, 1990--nearly 11 points--but then, that was during a recession. The real economy now is in good shape, and the likelihood of recession is considered low. The average risk premium over the past 18 years is just under five percentage points.
Even with the good yields, investors have yanked $9.9 billion more out of high-yield bonds this year than they put in. That compares with a $2.4 billion outflow for 1999, says TrimTabs.com Investment Research. One cause for the shrinkage is that, until recently, equities gave better returns. "My investors are still in love with the stock market," says Emerson Bell, a financial planner in Dallas. The contrary bet is that demand will increase as investors tally up their stock losses and start looking for alternatives.
Some junk-bond experts argue that the market isn't in such dire straits as it appears. Much of the recent bad news is coming not from original-issue junk debt, but from downgrading of higher-quality issuers such as Owens-Corning (OWC), Warnaco (WAC), and Champion Enterprises (CHB), which were rated junk in August and September. Pioneer's Margaret Patel says smart choices help investors skirt defaults and downgrades. "It's not like the pain is spread across all sectors; it's pretty specific," she says. Her fund is up 13.56%, the best performance of a junk-bond fund so far this year (table). She made a lot of money on technology bonds--most of which she still holds, including Quantum Corp. (DSS)--and has also taken a large stake in energy companies such as Parker Drilling.
Many high-yield analysts think the default rate will plateau this year. "By the time you have the maximum default rate, it's the beginning of the end [of the bear market in junk bonds]," says Sam DeRosa-Farag, global leverage finance strategist for Donaldson, Lufkin & Jenrette. The default rate hit 7.9% in 1990 and 8.8% in 1991, yet high-yield bonds soared 43.75% in 1991.
Some catalysts could touch off a comeback. Fidelity's Sorviero says merger and acquisition activity is bullish. He's upbeat on offshore driller Transocean Sedco Forex' (RIG) planned acquisition of oil services provider R&B Falcon (FLC) and Deutsche Telekom's (DT) purchase of VoiceStream Wireless (VSTR), a U.S. mobile-phone company. In both cases, the acquirer is a high-quality issuer buying a company with low-grade bonds. That raises those junk bonds' prices and reduces the supply.
To put some perspective on today's market, DeRosa-Farag points to the 1998 correction. The Russians had just defaulted on $40 billion in debt, and the collapse of Long-Term Capital Management nearly took Wall Street over the edge. Junk bonds were reeling, as dealers and investors shunned all but the highest-quality issues. Investors who bought at that time made out well over the next year, as prices recovered. In 1999, Patel's fund was up 27.37%. "We were fearing we were going into a recession," says DeRosa-Farag. "With hindsight, all those bonds were cheap."
The junk-bond market may not have bottomed out yet. But long-term investors invariably do better buying high-yield bonds or funds when they're out of favor.