Junk-bond chasers eye yields, downplay risks

Maybe it's a need for more income among investors tired of tiny-to-negative total returns from their mutual funds. Or maybe people are focusing on past performance.

Whatever the reason, investors seem to have embraced risk in 2003, and nowhere is this more apparent than in the rush to invest in high-yield-bond mutual funds.

High-yield (or "junk") bond funds had pulled in more than $21 billion by June 25 this year, according to AMG Data Resources in Arcata, Calif. That beats the previous record of $17.85 billion for all of 1997.

So far, these funds haven't disappointed. For the three months ended June 30, the average high-yield bond fund returned 8.9 percent, according to Morningstar Inc. in Chicago. So far this year, the average return from these funds was 14.3 percent, and the 12-month return was 17 percent.

Unlike funds that invest in US Treasury securities, municipal bonds, or high-grade corporate bonds, junk-bond funds concentrate on lower-rated corporate bonds. These bonds are rated Ba or below by Moody's Investors Service, Inc., or BB or below by Standard & Poor's Corp. Unrated bonds may also be included.

The rush into high-yield bond funds began in earnest last year, mainly as a way to replace some of the income lost from lower-yielding government and corporate bonds and bond funds. Now, investors are paying attention to total return, too.

"It may have started as a yield chase last fall," says Morningstar analyst Scott Barry. "We saw a lot of funds yielding 10 or 12 percent. Then, as total returns started to pick up, I think it became more of a total-return chase. Investors started to see a number of these funds with 8, 10, and 12 percent total returns and just piled on."

Also, as the economy improves, corporate defaults - an important measure of the strength of the high-yield market - are coming down, notes Martin Vostry, a research analyst at Lipper Analytical Services.

"So the default risk of these funds is declining as well, even though the economic recovery has not been as swift as some people may have hoped," he says. "The fact that more companies are able to refinance their debt at lower interest rates means they are defaulting less on their loans. I think that's a boon for the market as a whole."

In spite of the strong performance of these funds, they should still be handled with great care, analysts say. "If people are trying to get the same rate they got from Treasuries four years ago, they should know that there's definitely a big risk" in trying to do so with high-yield bonds, Mr. Vostry says.

For one thing, although the default rate in the high-yield market has improved, it would only take a couple of high-profile defaults or scandals - such as Enron or Adelphia Communications - to shake the confidence of investors in this market.

Or, if interest rates start to increase, which will happen eventually, some investors may abandon junk bonds in favor of higher-rated corporate bonds and Treasury securities. Either event could trigger a quick, dramatic sell-off in the high-yield market.

This potential risk is one reason the Vanguard Group closed its High-Yield Corporate Bond Fund to new investors last month and capped purchases by existing investors at $100,000 per calendar year. The Vanguard fund took in some $1.4 billion in the first five months of this year, roughly double the amount that was invested during the previous five months.

Usually, funds close because money is coming in too fast for portfolio managers to make careful investments. While that is a concern with this fund, Vanguard officials also may be trying to remind investors of the risks of these funds.

"We didn't do it to be paternalistic," Vanguard spokesman Brian Mattes said. "But we wouldn't disagree with the characterization, either."

The company also was concerned that, when the high-yield market does decline, many of the investors who have entered the fund in the past few months would leave just as quickly. This could force the portfolio managers to sell bonds they otherwise would have kept. "That wouldn't be fair to existing shareholders," Mr. Mattes said.

While some financial advisers have put small amounts of their clients' money in high-yield bond funds, others are more cautious - or avoid these funds altogether.

"If interest rates flip back up, then the net asset value [share price] of these funds will come down and a lot of people will start bailing out because of the perceived loss in value," says Craig Carnick, a financial planner in Colorado Springs, Colo. "That is going to be a horrible situation. It's happened in the past, back in the 1980s when interest rates flipped."

If investors are looking for income, Mr. Carnick suggests they instead consider preferred stocks and preferred-stock mutual funds, which pay a regular dividend, often every month.

In particular, Carnick recommends closed-end funds such as the Preferred Income Fund, the Preferred Income Opportunity Fund, and the Nuveen Quality Preferred Income Fund.

Closed-end funds are traded on the New York Stock Exchange and must be purchased through a broker. These three funds, however, have been yielding about 6.5 percent a year in dividend income.

The potential for dividend income, Carnick says, is another reason he prefers preferred stock and preferred stock funds over high-yield bond funds.

Under the new federal tax law, income - such as bond-fund income - is taxed at the taxpayer's top rate, which can be as high as 35 percent, unless the fund is held in a tax-deferred account such as an IRA. The top tax rate on dividend income, on the other hand, is only 15 percent.

"You can buy dividend-paying stock in very highly rated companies, get a 6 percent return, and get substantial tax advantages, with less risk,'' Carnick says.