Improved quality of junk bonds smooths comeback


The quality of junk is less strained, and that means more stable returns for those who invest in high-yield bond mutual funds.

"This has been a spectacular year for high-yield bonds," said Diane Vazza, director of fixed-income research for Standard & Poor's.

"The quality is solid. Defaults are the lowest they have been in years. The technical [factors] are solid. You have a good interest-rate environment and buoyant stock market. I have no fear for the near term."

"Junk" bonds are hybrids, as dependent on interest rates as on the economy.

"If economic growth gets too hot and the Fed cools it off by raising rates, it can slow economic growth, and that is not a good scenario for high-yield investors," said Ralph Stellmacher, who manages two high-yield portfolios for Oppenheimer Funds in New York.

But "as the economy hums along now in its current state of moderate growth, you have the opportunity for good earnings and cash flow," he said.

The better the earnings, the easier it is to pay off the debt. Defaults tend to decline and they are low now, Stellmacher said. The junk default rate so far this year is 2 percent, compared with 10 percent in 1991.

There are 165 junk-bond mutual funds. To find out what they invest in, check the funds' prospectuses or their annual reports.

It is a far different market than the one created in the 1980s, when Michael Milken and Drexel Burnham Lambert used junk bonds to finance billions of dollars in leveraged buyouts, some of which collapsed under the weight of their debt. Others defaulted in 1990 when Drexel, the only real market-maker, went under, taking along the junk-bond market, several insurance companies and numerous savings and loans that had invested in the bonds.

Since then, experts said, the quality of the bonds -- or "credits," as the fund managers call them -- has improved. And the market has more depth now because there are more players.

"Now there are 46 broker-dealers calling on me," said Roger King, who started two high-yield bond funds this year for the previously conservative Dreyfus Corp. "The higher quality of the credits has also allowed insurance companies and pension funds to come back into the market."

Instead of being used for leveraged buyouts, he said, a lot of junk bonds go to refinancing existing debt for companies that have track records.

"The quality of the bonds has been higher than in the past and there has been a lot more issuance of bonds to finance mergers and acquisitions," said Alice Lowenstein, fixed-income editor of Morningstar Inc. in Chicago, which rates mutual funds.

One advantage to investors is the record pace of mergers, fund managers said. Companies with investment-grade bonds are buying companies whose debt is rated BB and B, which makes those bonds more valuable.

In addition, if there is consolidation in an industry, even a company not acquired can see the prices of its junk bonds rise in anticipation of a possible takeover.

More than 40 percent of the credits issued are rated BB, which managers said are more directly correlated to interest rate movements than the lower B-rated bonds. The latter, also more than 40 percent of the market, are more reflective of the general state of the economy.

This year, said Jeff Koch, who runs the Strong High-Yield Bond Fund in Milwaukee, lower B-rated bonds have outperformed BB because the lower-rated bonds reacted more to the booming stock market. Interest rates rose about 1.5 percent this year before declining 1 percent, which affected the higher-rated junk bonds.

As a result, Koch said, the Lehman Brothers high-yield index was up 10.5 percent but the BB market was up 8.7 percent and the single B was up 11.9 percent. His fund is up 24 percent, leading high-yield funds in the Lipper ratings so far this year. "We were overweight in that B market. We took a more aggressive stance and that has benefited the fund," he said.

Koch said that one sign of the higher-quality trend is that during ++ the hot IPO market before the summer correction in technology stocks, some issues didn't make it.

"A lot of bonds came out and despite the frenzied pace of new issuance, there was discipline in the market and some deals did not get done," because they were not good enough, Koch said.

Also helping the industry were strong flows in the junk-bond market from insurance companies, mutual funds and pension funds, Stellmacher said. "Insurance companies and pension funds are allocating more money to high-yield funds for the greater return," he said.

So far this year, according to Lipper Analytical Services Inc., which tracks the industry, high-yield funds are up 12.2 percent while long-term Treasury bond funds are up only 1.88 percent and corporate bonds are up 3.2 percent. By contrast, Standard & Poor's 500 index funds are up more than 23 percent.

But not all junk-bond funds hold only high-yield corporate debt. Some buy emerging-market debt, which is up a startling 39 percent, according to Lipper.

Stellmacher is less worried about risk in emerging-market debt, both corporate and governmental.

"The risks are different, not necessarily greater, and there is little or no correlation between the emerging-market debt and the corporate debt," he said, which means one class of debt can rise or fall independently of another or move in tandem.

"By blending some of the risks in a high-yield portfolio you can benefit from the diversification and the low correlation," Stellmacher said, arguing that those political and currency risks were not necessarily greater risks.

But Lipper spokesman John Teall cautioned that political and currency risk were problems, as was country risk. Russia, which did well, "rewrites the rules on risk," Teall said.

Pub Date: 12/15/96

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