The Outlook's Outlook on Junk Bonds

11/15/2002 12:00 am EST


Many investors remain fearful of equities. At the same time, many worry that the three-year bond bull market could end as the economy improves. What's an investor to do? Standard & Poor's The Outlook says, "In this unsettled environment, some savvy investors are turning to what might seem a counterintuitive solution: high-yield or junk bonds." Mutual fund strategist Roseanne Pane offers S&P's outlook on junk bonds and some top bond fund picks in the sector.

"High-yield bonds carry a credit rating below BBB and have commensurately higher coupons because of their added risk. The best way to invest is through a mutual fund because you get risk-reducing diversity that would otherwise cost too much to obtain. Junk bonds have been out of favor for most of the past decade, after a good run in the early 1990s. Junk bonds are yielding on average about 14%, while the ten-year Treasury is hovering around 4%.That oversized yield helps to dampen volatility. In fact, junk bonds are inherently less risky than stocks because bondholders are in line to be paid back in case of bankruptcy. Stockholders stand to lose their entire investment.

"The best time to buy junk is at the end of a recession, when the yields are high and prices low. As the economy strengthens, yields go down because credit ratings improve, and prices go up. The high-yield funds described below have strong long-term track records and are managed by seasoned professionals. The rankings are determined by criteria set by our mutual fund analysts. They are based on risk-adjusted returns vs. the peer group.

"Kent Gasaway, who runs the Buffalo High Yield Bond Fund, says that when defaults start to decline as the economy improves, more people will go ahead and stretch for yield. 'Right now, they’re parked in risk-averse securities, not willing to take the risk. But when they are, I suspect that this sector will have a pretty sizable move.' One of Gasaway’s largest sectors is gaming, followed by health care, supermarkets, and hotels. He has recently been adding to the retail sector and technology.

"Columbia High Yield Fund, run by Jeffrey Rippey, invests the bulk of its assets in single- and double-B issues, with an average credit rating of double-B. This would make it somewhat less risky than the average junk bond fund. In comments to shareholders, Rippey said that longer term, he expects the high-yield sector to improve as the economy and corporate profits rebound.

"Pioneer High Yield Fund is managed by Margaret Patel, who does not expect a double-dip recession. 'I think the economy hit bottom and is very slowly rebounding. The problem is the acceleration has been slow,' Patel says. She believes that basic materials, paper and forest products, and transport-related capital goods companies will benefit. She also likes health care, including generic pharmaceutical companies and biotech firms, which are highly speculative but have a lot of liquidity to fund the search for novel therapies.

"'We run a pretty conservative fund relative to many of our competitors,' says Mark Vaselkiv, the portfolio manager for T. Rowe Price High Yield Fund. The overall credit quality of the fund is in line with the average junk bond fund, but Vaselkiv structures the fund to curb risk. The fund is broadly diversified, with the average position at 0.50%of total assets. Vaselkiv says the default rate in the portfolio is 1%this year vs. 8% or 9% for the peer group. 'Gaming, broadcasting, and energy are all industries that have good asset protection as well as good cash flow, and that’s why we emphasize them,' Vaselkiv says."


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