'Junk' may beat bailouts

The Baltimore Sun

Somebody has to finance America. Mark J. Vaselkiv is doing it.

As banks do little with bailout cash except pay executive salaries or lend it back to the government by buying Treasury bills, Vaselkiv aims capital at the stressed and unloved companies that are the only things between us and a depression.

He manages T. Rowe Price's $4.3 billion High Yield Fund, which invests in "junk" bonds and other risky debt.

Once an exotic, niche investment, high-yield credit has come to dominate U.S. finance as the number of junk issuers has surpassed "investment grade" corporations in recent years.

In this junk economy, junk investors may be more important than all the federal bailout programs combined. Unlike the government, funds such as Vaselkiv's are propping up struggling employers without your taxpayer dollars.

"We are open for business," he says a little proudly.

He and similar investors, he adds, "really need to demonstrate a little chutzpah, demonstrate some courage, because we've got to put these companies back on their feet. These are solid businesses that are going to survive in good industries."

If he's right, his investors will make a profit. That's something else you won't see in government bailouts.

The last time the economy was this bad, in the early 1990s, junk-bond funds went on to earn 50 percent over a couple of years. Panicked investors had oversold. Some issuers went bankrupt. But most didn't, and people willing to stake them in hard times were richly rewarded when the economy recovered.

This recession looks worse than the one almost two decades ago, and there is no promise the junk-bond upside will be as fabulous. But when you have bonds issued by well-known companies paying high interest in the first place and then selling for pennies on the dollar, things begin to look interesting.

For example, a travel slump and falling used-car prices have plastered Hertz, the auto renter. Its stock is down 80 percent. But it isn't anywhere close to the penury implied by its bond price a few weeks ago, when Vaselkiv bought Hertz bonds paying 10.5 percent interest at 35 cents on the dollar.

At that price, an investor is earning effective interest of 37 percent a year.

Deals like this are all over the economy. OK, maybe Hertz could default. But not every company rated junk will land in bankruptcy. Good funds diversify across issuers, and industries to make sure their stinkers don't outweigh their winners.

Plus, having paid only 35 percent of face value, Vaselkiv is likely to make money even if Hertz crashes. As a creditor, his recovery in bankruptcy proceedings would probably be higher than that.

As goes Hertz, so goes the nation. Hundreds of corporations have been downgraded, seen their debt trade at seemingly insulting prices and been blocked from new credit.

Vaselkiv's Hertz stake didn't benefit the company directly. Hertz issued the bonds before. But by bidding up Hertz paper, T. Rowe Price probably heartened the company's ratings agencies and helped revive the moribund market for new junk issues.

Some companies he infuses firsthand. The fund just invested millions in new junk floated by Cablevision Systems, a New York-based cable-TV giant, and El Paso Corp., a huge natural gas supplier. The fund's top holdings include bonds issued by Host Hotels, hospital operator HCA and miner Freeport-McMoRan.

It's not for the shy. High-yield bonds are "speculative" by definition and unsuitable for many pension funds and other risk-averse investors. Junk bonds posted a default rate of 16 percent in the early 1990s. This time, analysts believe the damage could be even worse.

But those on the front lines are also often the first to see things turn around.

Junk bond prices hit bottom in mid-December. The T. Rowe Price High Yield Fund is up more than 10 percent since then. The Hertz bonds Vaselkiv bought for 35 cents were being quoted at 53 cents this week - a 50 percent capital gain.

And investors are pumping money into the fund.

For the next six months, the economy will be "frightening and scary," Vaselkiv said. "But the high-yield market is so cheap that investors are looking through it and saying, 'If we get better a year from now, I'm really being paid to wait and own this high-yielding stuff.' "

Speculation has gotten a bad name thanks to the shenanigans of housing investors and oil tycoons. This kind of speculation, however, we could use more of.

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