If your desire for high investment income has led you to consider high current yield (or "junk") bond funds but your concern about their riskiness has led you to drop the idea, you may want to take another look.
High-yield bond funds typically invest in corporate bonds that are regarded as "below investment grade." They are so labeled because analysts question whether their issuers will be able to pay interest and repay principal as scheduled.
Such bonds appeal to some investors, who can afford the risk of investing in them, because their yields exceed those of higher quality corporate and government bonds.
For those who want to buy high-yield bonds but can't buy enough for diversification against defaults, well-managed high-yield funds are the way to go -- they can accept the risks inherent in a fund owning 75-100 low-grade issues. Although individual companies can default on their obligations at any time, waves of defaults are more likely during recessions, when more companies
earn too little to service their debts.
It was first the expectation and then the start of the recession that undermined the high-yield market in 1989-90, along with an increase in defaults. Prices also were hurt by other factors, including the liquidation of savings and loan associations' holdings of bonds and sales by mutual funds as a result of redemptions by concerned investors.
As yields of junk bonds rose, reflecting the troubled state of the market, an even more meaningful reading was provided by the margin by which they exceeded the yields of U.S. Treasury securities of comparable intermediate-term maturities: around 8 percent to 10 percent.
Last year, despite the recession, the situation changed sharply. As stock prices rose, many companies with outstanding junk bonds were able to issue new shares, paying off their debt with the proceeds and improving their credit quality while reducing the outstanding supply of junk bonds in the market.
As interest rates fell and companies were able, they called in high-coupon bonds for redemption and replaced them with bonds paying less interest. And even though corporate profits ,, were far from robust, the rate of defaults slowed.
All things considered, it was not surprising that the spread between yields of junk bonds and Treasuries was cut in half to around 4 percent. Nor was it surprising that, with the renewed strength in the high-yield bond market, high-yield bond funds staged an impressive recovery.
The 81 funds monitored by Lipper Analytical Services had an average total return in 1991 of 36.4 percent, compared with negative returns of 0.9 percent in 1989 and 11.1 percent in 1990.
Since 1991's performance is unlikely to be repeated soon, what can you expect of a high-yield fund now?
Michael A. McNamara, the Kemper Fund's portfolio manager and director of Kemper's fixed-income research, estimates a fund should generate a 15 percent total return this year: dividends of about 10 percent to 11 percent plus appreciation, if the economy recovers before long.
And what about the risk involved in junk bonds? "The quality is the highest I've seen in 10 years," says Merrill Lynch's Lathbury. "The default risk is relatively limited."