Junk bonds are weakening after several years of good times, creating a temptation for investors who might want to shift into mutual funds that focus on these investments. Junk-bond mutual funds attempt to generate high income by buying these low-rated corporate bonds, which carry hefty yields.
But analysts urge caution, arguing things could get worse before they get better.
By shifting money to junk-bond mutual funds, investors may attempt to generate high income by buying these low-rated corporate bonds, which carry hefty yields.
Indeed, junk bonds, euphemistically called high-yield bonds, aren't yet at bargain levels. And while the market is finally beginning to compensate investors for the risks they are taking with these funds, the pain could grow if the economy weakens. Junk-bond mutual funds have been among the most popular in recent years, and for good reason. The bonds, which generally do well when few companies default on their interest payments, have been in a long-running bull market. They've returned a total of more than 9.9% for investors in the past year, topping gains of 5.1% for higher rated intermediate-term bonds.
Drop in Yield
Yields on junk bonds, which move in the opposite direction of their price, have fallen from about 14% to about 8% in the past five years. Until two months ago, these bonds paid an interest rate of just over two percentage points above super-safe Treasury bonds -- minimal reward for embracing the risks of these low-rated bonds.
That's changing lately, however, as ongoing troubles in the market for debt-backed by mortgages of borrowers with lower credit ratings, big losses at some hedge funds specializing in bonds, and the cloudy investment outlook has investors worrying about all kinds of risky investments. Another issue: a torrent of new low-rated bonds and loans being sold, potentially overwhelming demand. Over the next few months, more than $200 billion of below-investment-grade loans and bonds will be sold to back big leveraged buyouts announced in recent months, such as Kohlberg Kravis Roberts's $26 billion acquisition of First Data. Already, a number of planned junk-bond offerings have been withdrawn, due to limited investor interest.
Yield Shift
As a result, high-yield bonds now trade at yields that are more than three percentage points above those of Treasurys, meaning that investors finally are receiving more compensation to venture into junk bonds. The average junk-bond fund has lost about 1.4% in the past month, the worst month in about two years. That explains why investors have pulled out more than $1 billion from the funds in the last month or so, after adding more than $3 billion earlier in the year.
Investors should resist the urge to jump into junk-bond funds because the market is only now starting to provide more reward for the risks of these bonds, analysts say, rather than creating a rash of opportunity. In Wall Street terms, investors are "repricing risk," or putting a new, lower price on risky assets, though the price is not yet at bargain-basement levels. To wit: Junk-bond yields were as much as 10 percentage points above Treasurys five years ago.
Quality Declines
Another worry: The quality of bonds in the high-yield market has dropped in recent years, as lower-quality companies have been able to find eager investors.
"It is absolutely true that investors are not being paid much extra yield to invest in high-yield bonds today," says Kevin Cronk, portfolio manager for Columbia Conservative High Yield Fund.
Some say there may be better bargains in the months ahead, perhaps as the market is weighed down by the upcoming cavalcade of new bond offerings.
Later Opportunities
"Now would not be a time to be adding to high-yield exposure to obtain above-average returns," says Martin Fridson, a veteran analyst of the junk-bond market who runs FridsonVision, a research firm. "As default rates rise" and junk bonds come under more pressure over the next two to three years, he says, there will be even better opportunities ahead to jump into junk bonds.
Mr. Fridson says that more-conservative investors might consider lightening up on their high-yield funds, but he doesn't recommend big moves because it may take time before any significant pain is felt in these investments that would offset the generous income they provide.
Indeed, bulls note that default rates remain very slim, and if the economy perks up a bit, it will be good news for junk bonds
At the same time, the recent selling has been indiscriminate, as investors sour on the entire sector, suggesting there might be some bargains for funds able to pick out strong companies that will be able to continue to make their high interest payments.
"Default risk, the chief nemesis of high-yield bonds, is near all-time lows and the outlook for defaults is very positive with most issuers enjoying ample liquidity for the foreseeable future," says Mr. Cronk.
"We believe that the recent sell-off in high yield has brought the market back to fair value and created some select buying opportunities," he adds.
Broader Funds
The best option may be sticking with high-yield mutual funds that are more conservative, or broader funds that can edge out of junk bonds if the going gets tough.
Lawrence Jones, an analyst at mutual-fund tracker Morningstar in Chicago, says "safety is the watchword investors should use right now in high yield" after a good run for these funds in recent years. "Not all high-yield funds are created equal."
Mr. Jones recommends funds that focus on higher-rated junk bonds, and do extensive research, such as T. Rowe Price High Yield (PRHYX), which he says is run by a team with a strong long-term record and is generating a yield of about 7.3%. Mr. Jones also likes Pimco High-Yield (PHYDX), which is generating a yield of about 6.7%.
Carl Birkelbach, president of Birkelbach Investment Securities Inc. in Chicago, recommends the Nuveen Municipal Market Opportunity Fund (NMO), a closed-end fund that buys higher-yielding municipal bonds that has fallen sharply lately. It sports a yield of more than 5%.
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