10% Yields in a 5% World - Junk bonds

Kiplinger's Personal Finance Magazine, April, 1999 by Steven T. Goldberg

You can easily increase your investment income--at the price of higher risk.

In springtime, an income investor's fancy turns to thoughts of ... beautiful high yields ... winsome double-digit yields ... fond reminiscences of the 1980s, when 30-year U.S. Treasury bonds yielded 15% and just slightly more-risque corporate bonds were even more fetching.

Wake up! Thirty-year Treasuries now hover around 5%, while yields on money-market funds and short-term bank certificates of deposit are just as unattractive. It's easy to get discouraged, but fortunately, there's reason for cheer. Largely due to fears of an economic slowdown, yields of 8% to 10% and higher are once again as abundant as daffodils.

Phoenix Alan is enamored of the yields he earns today. "I'm in it for the income, not the long-term growth, because there's not much inflation right now and, at my age, I'm not planning way, way into the future," says the retired lawyer, who lives near Naples, Fla. "I'd rather have money in the bank than speculative profits on stocks that may vanish tomorrow." Alan gets the income he wants from high-yielding, "junk" bond funds.

The more generous the yield you pocket, Alan knows, the greater the risk you must take. Before you invest in high-yielding securities, "you have to be willing to accept the risks and understand them," he says.

The majority of your income investments belong in safer--and, alas, lower-yielding--investments, such as high-quality municipal-bond funds offered by Vanguard and other fund firms. "We don't recommend that highyield bonds be more than 20% of anyone's bond portfolio," says Scott Brooks, a broker with Edward Jones in Carlsbad, Cal. But for a portion of your income money, stretching for yield can prove profitable.

JUNK BONDS

Because of fears of a global slowdown sparked by the weakness of emerging markets, you can earn 5.5 to six percentage points of yield more on most junk bonds than you can on comparable Treasuries--a gap wider than at any time since the junk-bond collapse of 1989-90. While a slowdown could make it hard for some bond issuers to make their interest payments, Martin Fridson, global high-yield strategist for Merrill Lynch, says that a big rise in defaults by bond issuers is unlikely.

Ben Trosky, manager of Pimco High Yield, recommends the 11.38% Globalstar Telecommunications bonds of 2004. With the cash generated by its bonds, which are rated B by Standard & Poor's, Globalstar plans to set up a low-cost satellite network to provide phone service to developing nations and other areas of the world (in competition with the Iridium network, spearheaded by Motorola). Globalstar's plans were set back last year when a rocket with a dozen of its satellites blew up in Kazakhstan. The bonds are trading at 76 cents on the dollar, giving them a fat 15.6% current yield.

Trosky also likes the 10% Riviera Holdings bonds of 2004, a mortgage issue on a Las Vegas casino. Rated B because of fears of overbuilding in Las Vegas, the bonds yield 12.6%. Even if the casino goes belly up, Trosky says, "the bonds would be covered just by the land value."

Alan used to buy individual junk bonds when he was working and could follow them every day. "Now, I do it through a fund manager. It's the same thing, but I don't do the work." An even bigger advantage of investing through a junk-bond fund is that if the issuers default on one or two bonds, it won't wipe out your whole portfolio. "For individuals, a fund is the way to diversify," says Kathleen Gaffney, co-manager of Loomis Sayles Bond. Institutional investors, such as mutual funds, also get better prices when buying and selling bonds than do individuals. Brokers sometimes have a hard time finding specific bonds in small enough lots for individual investors.

Fidelity High Income (800-544-8888), which yields 9.6%, is the top-returning junk-bond fund over the past five years and has finished in the top 35% or better measured against its peers every year since 1992. Northeast Investors Trust (800-225-6704), which yields 9.6%, is the top-performing fund over the past 15 years and has finished in the top 10% against its competitors over the past three and five years. About 10% of the fund is in stocks.

LESS-TAXING HIGH YIELDS

Tax-exempt municipal bonds may be the best bargain around. That's because even high-quality munis offer the same pretax yields as Treasuries with comparable maturities. "That's only happened three times this century," says Richard Ciccarone, director of municipal research for Van Kampen funds. "It's a rare opportunity."

Mary-Kay Bourbulas, who runs Strong High Yield Muni fund, recommends 5.95% Connecticut State Development Authority bonds for Connecticut Light & Power of 2028. These currently yield 5.9%. The bonds have a B , or junk, rating from Standard & Poor's largely because the utility owns part of a nuclear power plant. The bonds aren't guaranteed by the state, and the income may be subject to the alternative minimum tax.

She also likes the 4.75% North Carolina Medical Care bonds for Pitt County Memorial Hospital of 2028. Rated AA- by S&P, the bonds are currently yielding 5.2%. "It's a very high-quality hospital," Bourbulas says. Slightly more risky, single-A-rated, 5% Puerto Rico general-obligation bonds of 2028 yield 5.1%. Puerto Rican bonds have the added bonus of being exempt from state and local income taxes.