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Monday, November 18, 2002

By Len Boselovic, Post-Gazette Staff Writer

Like nervous worms gingerly poking their heads above ground to see whether the robins' morning feeding frenzy is over, investors are cautiously taking a look at junk bonds.

Junk bonds -- referred to in polite circles as high yield for the higher interest rates these borrowers must pay -- are riskier than debt issued by financially sound companies. They carry credit ratings of BB (as measured by Standard & Poor's) or Ba (on Moody's Investor Service's scorecard) or lower.

Typically, they move in tandem with stocks. The stronger their earnings, the more likely it is that junk bond issuers will make those hefty interest payments, providing a nice return to holders. Moreover, as a strengthening economy makes the payments less problematic, the bonds become more attractive so investors who bought them in riskier times can sell at a profit.

Junk bonds haven't fared well in recent years, battered by defaults from Enron, Global Crossing and other bubbles that burst. Through Thursday, an index of high-yield bond funds put together by Lipper, an investment research firm, had lost 6.25 percent this year and 2.3 percent over the last five years.

"The last four years have just been ugly," says Mark Durbiano, a Federated Investors senior portfolio manager who specializes in high-yield bonds.

That ugliness is reflected in the spread between interest rates on junk bonds and U.S. Treasury debt. The spread reflects how much more interest investors demand for accepting the risks junk bonds pose. Durbiano says the spread hit an all-time high of just over 11 percentage points early last month and has since narrowed to about 10 percentage points.

He and other analysts say another closely watched indicator, the default rate -- the percentage of high-yield borrowers incapable of paying their debts -- has probably peaked. Throw in an economy that appears to be on the mend and you can see why some believe high-yield debt is poised for a rebound.

"I think you have to be a little measured in your optimism because over the last several years, the high yield market has struggled," says Mike McGonigle, vice president of high yield for mutual fund operator T. Rowe Price. "We're not willing to stick our necks out too far on the economy right now."

Thomas Huggins, who manages high-yield portfolios for Eaton Vance, is also cautiously optimistic. While there were relatively few surprises in third-quarter earnings, Huggins isn't confident the slow growth economy will stay on track. If it reverses course, junk bonds will suffer.

"We think it's a little early to be trading down in the credit curve," he says. "Long-term, everything depends on earnings."

Huggins and other analysts believe many of the excesses that plagued junk bonds in recent years have been purged from the market. The plethora of high-yield debt that financed the tech and telecom booms of the late '90s for the most part has already exploded. Wall Street is more disciplined about buying new debt and demanding greater protection.

"The bond that hurt you in 2001 is gone," says Durbiano. "We've washed most of that stuff through now. For better or worse, it's gone."

Last year, there were about 40 out of about 175 issues in Eaton Vance's Income Fund of Boston [Ticker: EVIBX] that Huggins kept a wary eye on. Even though he's pruned many of those names from the fund, "there's still about 15 I lose sleep over," he says.

Given the risks, do junk bonds belong in a diversified portfolio?

In good times, junk bonds should account for no more than 20 percent of the fixed income portion of a diversified portfolio, says Charles Schilleci, president of Nexus Financial Group. He's apprehensive about taking the plunge now.

"I'm just not sold on the economy being out of the woods yet," Schilleci says.

Rick Pierchalski of Downtown money manager Berkowitz, Pierchalski, says the percentage of high-yield bonds in client portfolios ranges from 2.9 percent for investors who have principal conservation as an objective to 5 percent for those seeking aggressive growth.

"We are more comfortable with the sector as we think we are peaking in corporate defaults and that our clients are being compensated for risks attributable to these markets," Pierchalski says.

Investors tempted by junk bonds should consider high-yield mutual funds with a good track record. Look at their performance over at least five years, which Huggins says will give you a good idea of how a manager has done in a variety of economic climates.

According to Lipper, Eaton Vance's Income Fund produced annual returns of 0.85 percent for the five-year period ended Nov. 14. T. Rowe Price's High-Yield fund [PRHYX] returned 2.61 percent annually while Federated's High Yield Trust [FHYTX] lost 2.12 percent annually. The average high-field fund lost 1.97 percent annually over the same period.

Over 10 years, the Price fund ranked first out of 52 funds Lipper reviewed, returning 6.65 percent annually vs. 6.29 percent for the Eaton Vance fund and 4.65 percent for Federated's fund. The average high-yield fund returned 4.3 percent annually during the period.

In addition, take a look at the quality of bonds in a fund's portfolio and what industries they are in. The yields on funds packed with lower-rated bonds in severely troubled industries may be seductive, but they also pose more risks.

"One thing you should not do is shop the highest yield," says Durbiano. "The guy who shops the highest yield is taking the most risk, and that's where you get some nasty surprises."