Four High-Risk High-Yield Funds 

12/16/2008 11:28 am EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

Russel Kinnel, editor of Morningstar FundInvestor, and analyst Lawrence Jones warn about massive investor redemptions at some major high-yield bond funds.

Lack of confidence in markets and issuers has scared away buyers of some kinds of bonds, and that has meant some funds have been forced to sell at fire-sale prices.

So far we’ve seen the greatest problems at ultrashort-bond funds that held subprime debt. But we worry that this problem could hit high-yield funds—a much larger category.

The near 30% loss for the high-yield category as of the end of November resides in the fact that hedge funds, investment banks, companies issuing junk bonds, and individuals had taken on extraordinarily high levels of leverage. The financial panic made September and October the two worst months for junk bonds on record.

[So,] it’s not surprising to see significant redemptions from funds in the high-yield category. Through October, investors have withdrawn $3.2 billion from high-yield bond funds [this year]. Nearly two-thirds of that amount fled the category in the month of October.

So far, redemptions have only been a problem at a handful of high-yield funds, and the most notable—Regions Morgan Keegan Select High Income (MKHIX)—were largely involved in subprime securities. However, two more funds appear to be at risk: Oppenheimer Champion Income (OPCHX) and John Hancock High-Yield (JHHBX).

In the three months ending October 31st, Champion Income has seen near $114 million in net redemptions, but the worst is yet to come. That’s because the fund suffered a massive—near 55%—loss in November, in part due to the government’s announcement of shifting TARP priorities, which pummeled bond prices in various sectors.

The John Hancock fund has long plied the riskiest regions of the high-yield bond market (recently 53% of assets were in bonds rated below B, compared with the category’s average 14%). The fund is down 49% and has seen about 10% of assets leave the door.

Of two remaining funds that have seen significant outflows as a proportion of the overall asset base, Janus High-Yield (JAHYX) and Northeast Investors (NTHEX), the former would appear to be better situated to handle additional redemptions, because Janus’s management has built up the fund’s cash stake to help insulate the portfolio from recent market volatility, and it has remained generally cautious on credit quality.

Northeast, on the other hand, only has a modest 5.5% cash stake, holds more than twice the category’s average stake in the lowest-quality bonds, and has suffered both the worst absolute and relative returns of the ten funds under consideration. If investors continue to redeem this fund at an accelerated rate, management could be forced to sell low-quality high-yield bonds into a depressed and illiquid market, which could cause continued pain and a downward spiral.

While high-yield bonds appear quite inexpensive, they also look potentially treacherous. [Because] default rates could rise to [10% to 12% in 2009], we suggest limiting exposure here to no more than 5% or 10% of your portfolio.

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