Q&A: A Keen Eye for Valuable Junk

High-yield fund manager Patel thrives in bad times

Value-oriented investors like Margaret Patel believe that a market as beaten up as junk bonds offers bargains. The manager of Pioneer High Yield Fund has a knack for making money even when the overall junk-bond market slumps. Pioneer High Yield gained 9.1% this year through Oct. 26, vs. a 1.4% average loss for all junk-bond funds. Over the past three years, Pioneer High Yield has returned 19.2% on average annually, the best performance for a junk-bond fund during that period, according to Morningstar.

Patel attributes her success largely to avoiding areas that have had big blowups, like telecommunications last year and airlines more recently. She takes the unconventional tack of stashing about half of the $880 million fund in convertibles--bonds that convert into common stock if share prices climb to certain levels. Personal Finance Editor Susan Scherreik recently spoke with Patel about the outlook for the junk-bond market.

Q: How ugly is the bear market in junk bonds compared with those of the past?

A: This is as bad as it gets. In September, junk bonds fell an average 6.4%, the worst one-month performance ever. Junk bonds are trading at an average 75 cents on the dollar and yielding 13.4%. If you look at a longer period of time, junk bonds suffered slightly more during the 1990 recession.

Q: Are junk bonds poised for a rebound?

A: Not yet. Virtually every company in the high-yield universe was hurt by the events of September 11. Whatever slowdown in revenues and cash flow was previously anticipated will now be much more severe. That means many companies with only a small margin of error will break through that margin and be forced to file for bankruptcy.

Q: When will conditions improve?

A: I think we still have to wait another six months, at which point we'll start to see signs that the economy is doing better. The economy will accelerate throughout 2002 and end the year on a very strong note.

Q: So should investors stay on the sidelines for awhile?

A: It's tough to time the market. Junk bonds are a standout value right now. They're yielding 9 percentage points more than intermediate U.S. Treasuries, up from 7.75 percentage points in July. That yield spread more than compensates investors for expected increases in corporate bankruptcies and credit downgrades.

Q: Why else is the high-yield bond sector attractive?

A: An extremely positive backdrop to the junk-bond market is a Federal Funds rate that has fallen this year from 6.5% to 2.5%. So people who choose risk-free assets over riskier investments are giving up a great opportunity to earn a lot more. Investors need only a little bit of optimism to invest in the high-yield sector. That will happen when the outlook for the economy starts to stabilize.

Q: Following the 1990 recession, junk bonds staged their best rally ever, gaining 35% in 1991. Do you expect a repeat performance?

A: The entire junk-bond sector won't rebound, as it did in 1991. Companies with viable business positions will do better when the turn comes, but weaker ones will fall by the wayside.

Q: Why the bifurcation in the market?

A: You're seeing the inevitably high bankruptcy rates that occur after a period of very easy money. In 1997 and 1998, the economy was strong, junk-bond default rates were running at close to 2%, vs. over 9% today, and a lot of money was going into junk-bond mutual funds. So questionable companies that would never have issued bonds in a more stringent market did. They were companies that had poor business positions, often in industries that didn't have a very robust outlook. It's no surprise that three-quarters of the defaults this year were bonds issued in the late 1990s.

Q: Which sectors will suffer most?

A: Those sectors that already have disproportionately high default rates will continue to be poor performers, especially telecom. A year from now there will be few junk bonds of CLECs [competitive local exchange carriers], because many of these companies will have gone bankrupt.

Q: Which sectors are poised to do well?

A: We like energy, health care, building products, and some retailers. If energy prices hold steady or drop slightly--as we expect--energy companies will still enjoy strong cash flows. Health care will benefit as baby boomers age. Retailers and building-products companies should do well when the economy rebounds next year.

Q: What about technology?

A: Tech remains the fastest-growing sector of the economy, and a third of the fund's assets are in this area. I especially like semiconductors and semiconductor capital equipment. The sector was already in a severe recession, and because of the events of September 11, the bottom will be deeper. Companies that have a good business position and liquidity to ride out the next 6 to 12 months should do well.

Q: Why do you keep about half the fund's assets in convertible securities?

A: I use them because of my industry approach to investing. I look for industries that are attractive and companies that are well-positioned in those industries. I then look to see which bonds they have outstanding. Sometimes, there are very attractive companies that don't have straight high-yield bonds but they do have convertible bonds. Thanks to the equity correction we've had over the past year or so, a lot of convertibles are trading at yields that are competitive with high-yield debt.

Q: You do relatively little trading in your fund. Why?

A: This year--through September--the turnover rate for the fund was 22%. Last year, it was 45%, vs. 88% for the average high-yield fund. Market sentiment changes a lot faster than the financial reality at many companies. I look for companies that have enduring value and try to buy them when market sentiment has soured.

Q: What do you mean by "enduring value?"

A: Companies with enduring value have business franchises that are recognizable, are market leaders, and have patents or long-term relationships with customers that can't easily be dislodged. These companies have the means to weather difficult times. A perfect example is J.C. Penney, one of our largest holdings. Its bonds, which yield 9.9%, have gained 38% this year.

By Susan Scherreik

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