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Tips for Junk Mutual Fund Investors

Investments: Shopping for a fund? Be sure to check on management, bond quality and fees--along with performance.

August 01, 2000|THOMAS S. MULLIGAN | TIMES STAFF WRITER

NEW YORK — Junk bond mutual funds have generally been poor investments this year compared with other types of bond funds, such as Treasury funds.

But compared with the average stock mutual fund--which many analysts believe is a better benchmark for high-risk junk--returns haven't been disastrous.

The average total return of the 130 junk funds tracked by Morningstar Inc. is a negative 1% year-to-date.

Total return includes interest earnings plus or minus the net change in principal value. So the negative figure year-to-date reflects that, even as funds have paid out interest at annualized yields near or above double-digits, the income has been more than offset by declining fund share prices as bonds have slumped in value.

By contrast, investors in long-term Treasury bond funds have reaped an average positive total return of nearly 11% so far this year, counting interest income and Treasury securities' gain in value as a cash-flush Uncle Sam has continued to buy back debt.

Still, junk funds' average loss of 1% compares with a year-to-date gain of about 1% for the average stock mutual fund.

Because the junk market was weak last year as well, the average three-year annualized return on junk funds is a mere 2% now, according to Morningstar.

But this slump follows stellar returns on junk funds in the early and mid-1990s: The average total return on the funds was 16.5% in 1995, 13.7% in 1996 and 13% in 1997, for example.

With bond values depressed and yields up--the average junk fund now yields about 9.3%--junk bond advocates say this may be a good time to buy.

The big advantage of owning junk bonds via a mutual fund is that default risks are muted, because you own a basket of bonds rather than the handful of issues you might select on your own.

Still, if the economy were to tumble into recession, sending default rates even higher, all junk bond values would dive at least temporarily.

How to pick a junk fund? Here are some things to consider:

* Management. Many investors tend to buy funds based on their historical performance. That makes sense, says Morningstar bond fund analyst Sarah Bush. But she suggests going further and checking how long the portfolio manager has been in place.

"If you're buying based on a track record, make sure the [current] manager was responsible for that record," she said.

This is especially crucial at smaller fund companies, where the "bench" of junk-bond research talent may not be as deep as at a huge fund family, Bush said.

* Relative risk. Look into the quality of a junk fund's portfolio. Funds that posted particularly gaudy returns in 1996 and 1997, for example, probably were buying the hottest bonds of the moment--which also were the highest-risk bonds.

Study the part of a fund's latest financial report that deals with the quality of the securities it owns. Although all junk bonds are by definition below investment grade in quality, there still are gradations of quality in the junk universe: There is a big difference in relative safety from the BB-rated, high end of the junk-bond market to the CCC-rated low end.

If a fund's portfolio is concentrated in CCC-rated or unrated bonds, investors should realize that the high yields they may be earning come at a price of far higher default risk--especially if the economy weakens.

Dan Fuss, manager of the well-regarded Loomis Sayles High-Yield fund, said investors also should be aware of rules that can restrict fund managers.

Some funds' covenants require managers to stay fully invested in junk bonds even when they would rather be on the sidelines with some of the assets. "You don't want to have to invest," Fuss argues. "You want to be able to back away when things look bad."

* Expenses. Look for funds that keep annual management expenses under 1% of net asset value, Bush said. Because the Vanguard High-Yield Fund, for example, keeps annual expenses to a rock-bottom 0.29%, it is able to offer competitive total returns with a safer, higher-quality (and thus lower-yielding) portfolio than those of some rivals, Bush said.

* Other fees. A number of funds have begun imposing penalties for early redemption as a way to discourage market timers from jumping in and out.

Those penalties might benefit long-term investors, Bush noted. Excessive redemptions can force fund managers to sell bonds at deep discounts during periods of illiquidity in the junk market. That hurts returns for the investors who stay in a fund.

Early-redemption fees go back into the fund to compensate holders for the expense of cashing out departing investors--a policy that Bush endorses.

Among the junk funds that Morningstar has recommended recently are Janus High-Yield, Fidelity Capital & Income, Invesco High-Yield and Strong High-Yield Bond.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

A Sampling of Junk Funds

Here are 10 corporate junk bond mutual funds that have performed better than the average junk fund so far this year. "Total return" is interest earned plus or minus the net change in principal value in the period. "Current yield" is the so-called SEC yield, which is a standardized calculation. Data are through Wednesday.

*--*

Total return: Current 800 Fund YTD 3-yr.* yield** phone number MFS High Yield Opp. 4.9% NA 9.6% 637-2929 Janus High Yield 4.6 6.0% 9.4 525-8983 Eaton Vance Inc. Boston 3.1 8.1 10.2 225-6265 Strong S-T High Yield 2.9 7.4 10.2 368-1030 Loomis Sayles High Yield 2.8 3.1 10.2 633-3330 Mainstay High Yield Corp. 2.2 5.4 7.3 624-6782 Columbia High Yield 2.2 5.1 8.7 547-1707 Oppenheimer High Yield 1.6 3.7 11.1 525-7048 Vanguard High Yield Corp. 1.6 4.7 7.4 662-7447 Northeast Investors 1.3 3.0 9.5 225-6704 Average junk fund -1.0 2.0 9.3

*--*

* Average annualized return ** SEC yield

NA = not available (fund didn't exist for entire period)

Source: Morningstar Inc.

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