Junk bond funds - risky, yet rewarding

Junk suddenly looks very good.

Junk bonds, that is. Ask mutual-fund manager Dan Charleston.

His Seligman High-Yield Bond Fund returned a modest 1.3 percent last year. But for each of the past five years, it rose an average 10.1 percent, gaining a five-star performance rating from mutual-fund information-firm Morningstar Inc. in Chicago.

As the New Year begins, Mr. Charleston sees potential gains from the junk bond - or "high yield" - market.

Assuming the US economy only slows in the months ahead, without slipping into recession, as many economists expect, junk-bond funds should look attractive compared with alternatives such as Treasury and corporate issues, Charleston says.

Junk funds buy bonds carrying a rating of Baa or lower (as ranked by rating firm Moody's) or BBB or lower (as rated by Standard & Poor's.)

These bonds, which are highly speculative, come in two main types: Those deliberately issued at below investment-grade rating (which is A or higher), and "fallen angels," bonds that have fallen from their initial investment-grade ratings.

Companies that issue junk bonds usually have difficulty acquiring credit at favorable terms or their stock price is so low that an additional sale of shares is not worthwhile.

For income or bond-oriented investors, high-yield mutual funds provide an extra measure of diversification to one's portfolio. They can offer both a good income stream and the potential for price gains.

Junk vs. Treasuries

The compelling case for junk bonds now is the spread between interest rates on junk bonds and US Treasuries.

For example, the rate on 10-year high-yield bonds issued last October by PageNet is 10 percent. The bond's effective yield of 10.41 percent easily outdistances the 4.75 percent yields of comparable US Treasury bond issues.

That gap is "quite attractive," says Charleston, and should provide a buying opportunity for many investors.

It looked even more attractive three months ago. The spread shot up from about 5 percent in early fall to about 7 percent by November; it has now narrowed somewhat, but is still 5.5 percent to 6 percent above 10-year US Treasury securities.

And Charleston thinks the spread may start to narrow. So investors who buy junk now will not only benefit from the high interest rates but also from rising prices if those rates start to fall.

Junk bonds have not always looked like a savvy investment, Charleston notes. Through November, intermediate government funds are up 6.9 percent on average; intermediate-term bond funds, which hold both US and corporate bonds, are also up 6.9 percent, and long-term government bond funds are up 11.3 percent.

By contrast, the 120 high-yield bond funds tracked by Morningstar are down 0.4 percent for that period.

Why then buy into a junk-bond fund now? As Charleston notes, because spreads are now higher than usual and because junk bonds tend to do well in a steady economy.

"A play on junk bonds is in part a play on the small-cap sector," since they tend to be issued by smaller firms, says Eric Jacobson, fixed-income editor at Morningstar.

Many fund experts believe that the current market environment - with slowing or steady growth - favors small companies. And, in fact, this small-cap segment of the stock market appears to be slowly flexing its muscles in 1999.

So owning shares in both a small-cap fund and a junk-bond fund could provide a double whammy for adventuresome fund buyers, some experts say.

Remember the risk

That said, most market experts believe average investors should limit their junk-bond holdings, since they do entail higher than average risk.

Charles Carlson, editor of an investment newsletter called DRIP, recommends junk-bond funds for no more than 10 percent to 15 percent of your portfolio.

Junk funds favored by Mr. Jacobson of Morningstar include Seligman High Yield (800-221-2783). Invesco High Yield (800-525-8085, up 1.5 percent last year, but down 0.02 percent through Jan. 15), and Northeast Investors (800-225-6704, down 0.25 percent in 1998, but up 0.57 percent through Jan. 15).

Junk-bond funds offer both a good income stream as well as the potential for price gains.