WSJ/Getting Going: Stock Investors Could Stand A Little 'Junk' in Their Diets
November 13, 2001
By JONATHAN CLEMENTS
Hungry for healthy stock-market returns? Here's an intriguing suggestion: Buy junk bonds.
Like stocks, junk (or "high yield") bonds have had a rough time lately. Mutual funds that invest in junk bonds tumbled an average 8.1% last year and shed an additional 1.8% in this year's first 10 months, according to Chicago researcher Morningstar Inc.
Stocks, of course, have suffered even more. Still, I believe there is a decent chance that high-yield bonds, those risky securities issued by heavily indebted companies, could outpace stocks in the years ahead.
As I have argued in many columns this year, expected stock-market returns remain modest, despite the 30% decline in share prices. The outlook seems especially grim for blue-chip U.S. shares, which continue to sport nosebleed share-price-to-earnings multiples and skimpy dividend yields.
By contrast, junk bonds today offer lush 13% yields. Don't believe junk-bond prices will rebound soon? As they say on Wall Street, you are getting paid to wait.
"One of the reasons investors may gravitate in this direction is, in part, because they don't see a lot of upside in stocks," says Martin Fridson, chief high-yield strategist at Merrill Lynch & Co. "They might say, 'Ordinarily, I'm not that excited about bonds, but that 12% or 13% looks pretty attractive right now.'"
Today's 13% yield is some nine percentage points higher than the yield on 10-year Treasury notes. How unusual is that? Put it this way: The spread between junk and Treasury yields was only slightly wider during the economic turmoil of 1990-91.
That was the last time that junk bonds got really pummeled, and many investors still remember the pain. In the late 1980s, unscrupulous securities salesmen hawked junk-bond funds as higher-yielding certificates of deposit.
That fantasy was shredded in late 1989 and 1990, as junk-bond issuers struggled with an overdose of debt and a slowing economy. Junk-bond funds proved anything but safe, as their rich yields failed to compensate for shrinking fund-share prices.
But for those who hung tough, the story had a happy ending. After getting hammered in 1990, both junk bonds and stocks came roaring back in 1991. In fact, in 1991, junk-bond funds soared an average 37.1%, rivaling the performance of diversified U.S.-stock funds.
Naysayers might dismiss the parallels, noting that the economy is likely to deteriorate further in 2002, triggering a rash of defaults among junk-bond issuers. But that won't necessarily mean lousy junk-bond returns, says Ken Gregory, president of Litman/Gregory, a money manager in Orinda, Calif.
For instance, 1991 was a terrible year for junk-bond defaults, and yet the bonds posted fabulous gains. "Like every other financial asset, high-yield bonds discount the future," Mr. Gregory notes. "There are a lot of defaults forecasted for next year, but that's not inconsistent with high returns."
In 1990-91, junk bonds and stocks seemed to move in lockstep, first losing money together and then rebounding together. But junk bonds could do well in the next few years, even if stocks don't.
Mr. Gregory reckons that the worst-case scenario for junk bonds is "a zero return over the next 12 months," as slumping junk-bond prices and defaults wipe out the entire gain from the 13% yield.
"I think the downside in stocks is a lot greater than that," Mr. Gregory says. "It's hard to argue that the stock market is at bargain levels. Over the next five years, I see annual returns of maybe 3% on the low side and 9% on the high side."
By contrast, junk bonds seem to offer far higher potential gains. Historically, junk-bond investors have lost 2% a year to defaults. Even if you subtract two percentage points from today's 13% yield, that still leaves investors collecting 11%. And returns could be much higher, if junk-bond prices bounce back.
If you are intrigued by junk bonds, consider no-load funds such as Fidelity Capital & Income, Northeast Investors Trust, T. Rowe Price High-Yield, Strong High-Yield Bond and Vanguard High-Yield Corporate. According to Morningstar, all have expenses below 1%, managers with better-than-average five-year records, and investment minimums of $3,000 and below. Because junk funds are so tax inefficient, they are best held in a retirement account, unless you plan to spend the income.
Here's an added consideration: Don't buy a fund that has done too well this year. Again, cast your mind back to 1990-91. The 50% of funds that held up best in 1990 went on to gain an average 32.8% in 1991. But the funds that got hit hardest in 1990 did even better in 1991, climbing 42.1%.
That suggests the best funds to own may be those that have made little or no money this year. "If you look just at the funds that have done best this year, you're limiting yourself to the higher-quality high-yield funds," Mr. Gregory says. "We would rather look at funds that we consider pure plays."
Write to Jonathan Clements at jonathan.clements@wsj.com1
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