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Hungry Investors Filling Up on 'Junk'

High-yield but risky bonds beckon people tired of paltry returns on other securities.

March 31, 2003|Tom Petruno | Times Staff Writer

On Wall Street this year, "junk" has been anything but.

Corporate high-yield junk bonds -- those issued by companies considered to be below investment grade -- have collectively been one of the few bright spots in U.S. financial markets.

Strong demand for the securities has driven prices up and yields down. The result has been returns of 5% or more on the bonds in the first quarter, while most major stock market indexes are in the red and high-quality bonds have struggled to stay in the black.

The healthy performance of the junk bond market also suggests a much brighter view of the economy -- because, in theory at least, people wouldn't be loading up on these issues if they believed another recession was imminent.

But that also points up the risk in junk bonds: If the economy stumbles again, the junk market almost certainly would go with it.

For now, investors are responding in part to more favorable fundamentals. Default rates on junk bonds are coming down after soaring in recent years as the struggling economy pushed many financially shaky companies into bankruptcy, according to John Lonski, an economist at Moody's Investors Service in New York.

In the 12 months through February, Moody's calculates that about 7.5% of outstanding junk issues went into default, meaning the companies couldn't make interest payments owed to bondholders. By contrast, the default rate was about 10.8% in the 12 months through January 2002, Lonski said.

The message of the junk market's performance this year is that "many companies that were on the cusp of liquidation are going to survive," said Stanley Nabi, a managing director at Credit Suisse Asset Management in New York.

As the risk of default ebbs, the high interest yields on junk securities from companies such as Levi Strauss & Co., Bally Total Fitness Holding Corp. and Level 3 Communications Inc. are beckoning many investors who are fed up with the paltry rates offered on higher-quality bonds.

The average annualized yield on an index of 100 junk bonds tracked by KDP Investment Advisors was 9.8% Friday, nearly a four-year low and down from 10.6% as of mid-February.

Yet even though junk yields have fallen, they're still far above the 3% to 5% yields available on longer-term Treasury securities.

But it's more than income-oriented investors who are favoring junk securities, said Raymond Kennedy, who manages junk bond portfolios for Pimco Funds in Newport Beach. He believes that one big group of buyers is made up of what he calls "scared equity investors" -- people who might ordinarily buy stocks to make a bullish bet on the economy, but who now feel safer making that bet with high-yield bonds.

That group may include investment legend Warren Buffett. This month, in his annual letter to shareholders of his Berkshire Hathaway Inc. holding company, Buffett said he had little interest in buying stocks, but that he continued to make investments in junk securities.

His words helped focus other investors on junk issues, said Margaret Patel, high-yield bond fund manager at Pioneer Investment Management in Boston.

Buffett "sprinkled holy water on the whole thing," she said.

Risk-averse investors have good reason to feel better about junk securities than stocks. Last year, though prices of many junk bonds fell along with stock prices, the high interest generated by the bonds limited junk investors' overall losses.

The average junk bond mutual fund had a "total return" of negative 1.7% in 2002, according to fund tracker Lipper Inc. Total return is interest income plus or minus principal change.

That was a small loss compared with the Standard & Poor's 500 index's total return of negative 22.1% last year.

This year, through last week, the average junk bond fund's return was 5.2%, according to Lipper, while the average domestic stock fund is showing a loss of 1.5%.

Some junk investors figure it's high time for the sector to shine. A surge in defaults -- led by companies in the telecommunications industry, a heavy issuer of junk bonds in the late 1990s -- and the economy's struggles since 1998 have meant a long period of lousy performance for junk owners.

Over the last five years through last week, the average annualized total return on junk bond mutual funds was a negative 1.1%, according to Lipper. By contrast, investors in long-term government bond funds earned 6.4% a year in that period.

Many junk-rated companies continue to struggle financially, with dire implications for their bondholders. That list includes many airlines, power companies, and even such former blue chips as Goodyear Tire & Rubber Co.

For the $675-billion junk bond sector as a whole, however, veteran investors are looking back to 1991, when the junk market rebounded dramatically after plummeting with the 1990 recession. The average total return of junk mutual funds in 1991 was a stunning 37%, Lipper data show.

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