Investors Jump On Junk Wagon In Search For Yield Risks Lower Now, But Spread Over Treasury Bonds Down, Too

Not since the heyday of Michael Milken in the 1980s has the junk-bond market drawn so much attention from investors.

Mutual funds specializing in high-yield bonds - the label that the bonds’ purveyors prefer - are experiencing record inflows as investors seek out the attractive double-digit yields that the stock market is incapable of providing at its current record-high level.

But junk bonds are not for the faint of heart. And first-time investors might find that they jumped on board just in time for a good drubbing.

That’s what happened to those who tried to emulate junk-bond king Milken in 1990-91, when the more outrageous bond-financed leveraged buyouts of the 1980s crashed and burned.

A starting point for any discussion of junk bonds, which are corporate bonds rated below investment grade (BB or lower), is James Grant, editor and publisher of Grant’s Interest Rate Observer.

He’s the intellectual compatriot of that man in the cartoon who sports a long, white beard and a sign proclaiming, “The end is near.” Surely if anyone is raising caution flags about investing in junk, it would be Grant.

“There’s no disputing that the junk of this era is much better quality than the junk of the late 1980s,” Grant said, his voice tinged with caution.

So what’s the problem? “They’re extremely expensive,” he said. “The yields are tightly compressed by historical standards” to yields on U.S. Treasury securities.

Usually the spreads are wide, because Treasury issues are considered the most creditworthy and junk bonds the least.

How does Grant explain the rush to junk?

“People are on their hands and knees with flashlights looking for the extra basis points,” he said. (A basis point is a hundredth of a percentage point). “It suggests people are very confident about the future and credit risk. It’s a poor time to join the herd and go for the extra few basis points because you’re not being paid for the risk,” he said.

Before turning to sample the opinions of those high-yield fund portfolio managers, it makes sense to sketch out the changing shape of the junk-bond market, now estimated at $375 billion and rising. A decade ago, the largest share of issues was used to finance takeovers or to refinance previous takeovers.

During the 1989-90 junk-bond debacle, when financiers such as Robert Campeau of Federated Department Stores infamy declared bankruptcy and junk bond funds lost 25 percent of their value, junk-bond refinancings soared to 65 percent of the category.

But last year, acquisition financing and refinancing accounted for less than 16 percent of all junk bonds issued. Taking its place and accounting for nearly half of the junk-bond issues last year were those used to refinance bank debt or retire older corporate bonds that had been issued for general corporate purposes. Another fifth of the financings went into corporate coffers.

Indeed, cable television, satellite firms, media organizations and small telephone companies have become major users of the junk-bond market. They’re turning to the bond market as an alternative to bank financing for their riskier, entrepreneurial activities.

“Yes, some are risky, highly leveraged firms, but ‘junk’ is an inappropriate title,” said Dan Charleston, portfolio manager of the $1.18 billion Seligman High Yield Bond Fund. “The credit quality of these issuers is much stronger than the image would suggest.”

One key measure for Charleston is the interest coverage ratio, which compares a company’s earnings before interest payments, taxes, depreciation and amortization, known as EBITDA, to its interest expense. In the late 1980s, that ratio stood at just 1.4; today, it’s 2.4 for high-yield securities, Charleston said.

Another big change in the market is the amount of information available to investors. With many more pension funds, mutual funds and individual investors in the junk-bond hunt, investment bankers bringing the deals to market for their clients face greater scrutiny by managers unwilling to take a flier with somebody else’s money.

“I don’t believe the world has changed and that default rates will always be lower,” said Martin Fridson, a senior analyst at Merrill Lynch & Co. and frequent commentator on the state of the junk-bond market. “But in today’s market, the ‘other people’s money’ schemes have been eliminated. In the deals being done today, all the players have genuine risk.”

Although junk-bond quality is better, it’s a relative concept. The balance sheets of companies that issue them don’t justify investment-grade ratings from agencies such as Moody’s Investor Services and Standard & Poor’s Corp.

The improved quality has dropped the bonds’ relative yield to a level that is low by historical standards: just 2.7 percentage points higher than the comparable 10-year Treasury bond.

Over the last five years, the Merrill Lynch high-yield index has averaged 5.5 percentage points more than the 10-year Treasury note. In 1990, when the junk-bond market tanked, it reached 10 percentage points.

Still, that hasn’t stopped thousands of new investors from rushing into the junk-bond market in the last year.

For example, the $1.73 billion Northeast Investors Trust fund, which has averaged a 10.36 percent total return - yield plus capital appreciation - over the last 10 years, took in nearly 60 percent of that cash in just the last 15 months.

Its chairman, Ernest Monrad, who has been running the junk-bond fund since 1969, said, “Some people say I should have been in stocks since 1982 because the market has tripled. But I would argue that’s the riskier place to be in the near term.

“Our sector has a tremendous advantage because we give a 9 percent return right out of the gate. All we have to do is earn 2 to 3 percent on capital, and we beat most investments.”

All the major funds say they spend much time and money investigating firms with using junk financing. Not everything measures up. “Regional phone companies and cable companies - that’s venture capital masquerading as bonds,” Monrad said. “We’re steering clear of that as are the better fund managers.”

High-yield funds have become an important play for managers seeking high returns for retirement accounts, because the dividends aren’t taxed as long as they remain in the fund. “Eighty percent of our dividends are reinvested,” Monrad said.

Not all is rosy on the junk-bond front, however. As funds scramble for investors’ cash in a declining-yield environment, they could start dipping lower down the quality scale to boost their yields.

So what happens when the economy sours and many of these below-grade financings go into bankruptcy? Junk-bond boosters have answers for that, too.

They point to the funds’ diversification, which lowers their risk.

And portfolio managers say the better credit quality today has mitigated at least some of that risk. “If the economy collapsed today, I would much rather be in high yields than equities,” said Seligman’s Charleston. “In the next downturn, these bonds will behave much more like other bonds than stocks.”