High Time for High Yield - investing in junk bonds - Statistical Data Included

Kiplinger's Personal Finance Magazine, August, 1999 by Brian P. Knestout

Junk bond funds had a rough year in 1998. Now they're making up for it.

You can never have enough money to retire on," says Don Benisch. But the 56-year-old farmer and woodworker from Marshall, Wis., doesn't like laboring over the management of his retirement portfolio. He prefers to stand back and let the funds work for themselves. "I don't like to pay too much attention to my funds," he says. "I just like to draw the cream off the top to live on."

That kind of hands-off approach demands sharp fund picking and a savvy mix Of funds that will protect a retirement account from hazards ranging from inflation to plummeting stock prices. So on the advice of Terry Balding, a financial planner, Benisch invested a portion of his portfolio in high-yield bond funds--portfolio diversifiers that gush with current income.

ONE MAN'S JUNK

High-yield bond funds invest primarily in non-investment-grade bonds (those with a quality rating below BBB as rated by Standard & Poor's or Baa by Moody's) that provide substantially higher interest payments than investment-grade corporate bonds. Also called junk bonds, they are issued by companies with less than blue-chip financial security that may need a strong economy in order to prosper.

As a result, investors should use high-yield funds only as a part of a balanced portfolio because they entail a special risk. If the economy sags, the funds pay a severe penalty as prices plunge on the bonds they own. In fact, high-yield funds can experience price declines merely on the possibility of an economic slump.

For example, in the late summer and early fall of 1998, prices of high-yield bonds fell dramatically because investors feared that troubles in Russia would send the U.S. economy into a recession. The recession didn't happen, but the typical high-yield bond fund lost 10% of its asset value during the three months ended October 30, even though investment-grade bond funds advanced 2% during the same period.

During the shallow recession of 1990-91, another risk came to light. More than 10% of high-yield bonds defaulted on interest payments. Over the past 20 years, the default rate on high-yield bonds has averaged a much less terrible (but still serious) 2.8% a year. Hence the derisive "junk" moniker and bad-boy reputation.

ANOTHER MAN'S TREASURE

But owning high-yield bonds for the long term has clearly been a winning strategy during the past two decades. Aided by yields averaging about five percentage points higher than comparable U.S. Treasuries, junk funds delivered higher total returns than their investment-grade counterparts over the past three-, five-, ten-, 15- and 20-year periods. While default remains a risk, the diversification that comes with a fund's portfolio (the average high-yield fund has 193 bond holdings) acts as a buffer against it. Since high-yield bonds pay higher coupons and benefit from the same economic factors that boost interest rates, they are less vulnerable to rising interest rates than longer-term, higher-quality bonds.

Even though 1998 was a poor year for high-yield funds, it provided a textbook example of how they move independently of both investment-grade bonds and stocks. That makes them an ideal diversifying tool in a long-term, income-oriented investor's portfolio because the door swings both ways: In six of the past eight years, the returns on high-yield funds surpassed investment-grade funds, and high-yield funds are trouncing investment-grade funds so far this year.

THE JEWELS IN THE CROWN

The five funds described below consistently end up in the top deciles for return in this category over the previous three and five years--and for even longer periods in the case of older funds. All levy minimal annual expenses that would otherwise hamper total return, and none has a sales fee to put a dent in the amount of initial capital that can be put to work. Yet each fund takes a different approach toward picking bonds. Yields are for the 30-day period ended June 14 unless noted otherwise. Yields are stated at an annualized rate and may differ from the 12-month yields shown in the tables that start on page 141.

Leading the pack is Fidelity Capital & Income, whose 12-month total return of 7.6% makes it the highest-returning junk-bond fund over the past year. Manager David Glancy, who took the fund's reins in 1996, guided Capital & Income to a 4.8% return in 1998--handily beating more than 90% of his peers--and the fund's year-to-date return in 1999 of 11.4% bests even Standard &Poor's 500-stock index by five percentage points.

Capital & Income can invest in stocks--an option that Glancy invokes sparingly. Instead, he invests primarily in no-nonsense junk bonds across a broad spectrum of industries (including bonds of energy, retail and telecommunications companies) and places a small portion of assets in high-yielding preferred stock. Common stock accounts for about 10% of the fund's current portfolio.

This strategy has kept both returns and yield (currently 9.86%) high, regardless of the sector or industry currently favored by the high-yield market. Glancy also prefers bonds with short maturities, which helps to tone down the fund's higher-than-average volatility.