Why Junk Bonds Suddenly Look Good

An economic rally already is under way. A junk-bond fund could be the best way for investors to ride it

Everyone calls high-yield bonds junk. Since late 2000, when I first moved some money their way, I've also called them promising, puzzling, exasperating, disappointing, and another name or two unfit for print. It's not that they lost money last year. Junk funds yielded about 10.5%, so even with prices of their underlying bonds falling, they returned 1.8% on average, according to Morningstar. Yet they in no way anticipated the economy's recovery, as they did so gloriously in 1991, when the average fund leapt nearly 37%. They stumbled into 2002, losing 1% through February.

Right now, though, I suspect my luck in junk is changing. Signs of a stronger economy, from higher factory output to lower jobless claims and the Federal Reserve's more bullish outlook, keep coming. With them, the prices of junk bonds are jumping. "We've had a big advance," Martin Fridson, Merrill Lynch's chief high-yield strategist, told me. He noted that in the first 19 days of March, Merrill's high-yield bond index returned almost 2.5%. Annualized, that comes to 59%. Are junk funds again bound for glory?

No, at least not on the order of 1991's returns. Back then, junk-bond prices got a huge boost from falling interest rates. Now, the general level of rates is rising. Yet three big reasons suggest the rest of 2002 should be much friendlier to junk-bond investors. First, average yields on junk remain between 6 and 7 percentage points above those on comparable Treasuries. That's high, since the historical average is closer to 5 percentage points and has dipped below 3. As business improves and credit risks lessen, the gap should narrow, sending junk prices up.

Second, it's likely that as the record volume of bonds issued in 1998--the shakiest recent vintage--matures, the rate of defaults will top out. "We think the peak will be within three months or so," said Earl McEvoy, portfolio manager of the nation's largest junk fund, Vanguard High-Yield Corporate Bond. Finally, there's the possible onset of a virtuous cycle, with higher junk-bond prices drawing more investor cash into the market, driving prices still higher. In mid-March, junk funds posted the heaviest inflows since 1997, according to Arcata (Calif.)-based AMG Data Services. Such mega-investors as California Public Employees' Retirement System, or CalPERS, also are vastly expanding junk portfolios.

It's only the richest and most motivated individuals who can sensibly trade junk bonds directly. The market is overwhelmingly dominated by institutional investors. The rest of us have mutual funds--140 of them at Morningstar's last count. You only need one good one, though. I've picked three possibilities (table), each on the conservative side. That is, these funds buy bonds of somewhat better credit quality than the average junk fund. That makes them less susceptible to defaulted bonds but a bit less promising, too. "If high-yield has a real strong run this year," Columbia High Yield Fund Co-manager Kurt Havnaer warned me, "some of the riskier funds will put up bigger numbers."

Two more bits of advice: Before buying a junk fund, know how long you can commit your cash. You may have to wait more than a year or two to see a payoff. Know, too, what to look for as signs that the rewards of junk are being eclipsed by the risks. One is the spread in yields between junk bonds and Treasuries. As it shrinks below four percentage points, it's time to see if other investment options offer better prospects.

Another clue is the default rate on junk, tracked monthly by Moody's Investors Service (http://riskcalc.moodysrms.com/us/research/mdr). In February, it dipped to 10.5%. Over the long term, the rate has averaged 3% to 5%. Below 3%, Fridson told me, start worrying. "People will say, `You're crazy, the world is great!' But a more sensible thing is to say at that point: `We've had a great ride."' That's for later. Right now, my money says this ride is just revving up.

By Robert Barker

    Before it's here, it's on the Bloomberg Terminal.