Top Junk Bonds: Trash or Treasure?

04/11/2003 12:00 am EST


After five years of flat or negative returns, high yield bond fund managers expect that their funds will at least earn their coupons, which are about 9%, this year. But total returns could soar into the double digits when the economy improves; for yield-hungry investors that could turn out to be a once-in-a-decade opportunity. Over the past three years, high-yield bonds funds have performed about midway between stocks and investment-grade corporate bond funds. The average high yield fund lost 2.8% annually in the three years ending 2002. On a positive note, high-yield bonds have acted independently of both stocks and bonds. A sluggish economy and a record number of bond defaults contributed to the 2002 malaise. High-yield issuers remain highly leveraged. In the past, they reduced debt by issuing stocks. But that hasn’t been an option over the past few years as demand for stock offerings have dwindled. Defaults on high-yield bonds were more than 12% last year, falling to an 8% rate this year according to Moody’s. That’s still double its historical average of 4%.


“Today, however, fund managers say the excess has been squeezed out of the market.  The default rate is declining and many companies have cut costs and strengthened their balance sheets. The big question is when will the economy head back. Margaret Patel, manager of the Pioneer High-Yield Fund (TAHYX), estimates that high-yield bonds could register a total return of around 10% this year, but a lot depends on how the economy performs. She adds that we might have to wait until mid-year when economic stimulus and tax cuts kick in. For now, she owns companies that are leaders in stable, expanding industries. They must have unique products and stronger balance sheets than their peers. The fund’s largest holdings include Ivax Corp. (IVX AMEX), the generic drug company; Crescent Real Estate (CEI NYSE), with strong demand for its properties in Texas; and Freeport-McMoRan (FCX NYSE), gold miner.


Kevin Akioka, manager of the Payden & Rygel High-Income Fund (PYHRX ) says, ‘Yield spreads are now very attractive; indeed, they are so strong they don’t even need economic growth to perform well.’ He now favors lower-rated issuers instead of fallen angels.  The reason: many fallen angels have weaker bond covenants than bonds originally rated B. Among his largest holdings are Allied Waste (AW NYSE), the country’s second largest waste management company, and Williams Scotsman , the second largest mobile office and storage company. Allied bonds yield 10% while the company has solid cash flow and is paying down debt. Williams’ bonds yield 12% while cash flow is stable and growing.


Bruce Monad, manager of Northeast Investors Trust (NTHEX), is investing in California utilities because they represent good values. He owns Pacific Gas & Electric (PCG NYSE) and Edison International (EIX NYSE). He also favors entertainment and has a sizable stake in AMC Entertainment (AEN AMEX). AMC has low debt levels and is the second largest theater company. He also likes Pathmark Stores (PTMK NASDAQ), which does strong business in urban areas.


Mark Durbiano, manager of the Federated High-Yield Trust (FIHBX ), expects default rates to continue to decline. Top holdings include Health Care Corp. of America (HCA NYSE) and Premier Parks (PKS NYSE). Both firms show stable demand and cash flow. One area he is finding values is in the lodging sector. The hotel business still is feeling the effects of 9-11. But he favors Starwood (HOT NYSE), Host Marriott (HMT NYSE), and Hilton (HLT NYSE) because the companies have strong franchises and assets. And while underweighted in tech, he likes Qwest (Q NYSE) and U.S. West (USW NYSE), because the bonds have been beaten down. ‘The real question is not if the US economy and high-yield bonds will recover,’ he says, ‘but it is when they will recover.’”

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