Junk?

High-yield bonds, which have been called junk for a reason, aren't living up to their nickname. As an asset class, high-yield funds, which represent the best way for advisors to expose their clients to junk bonds, were off by an average of just 0.67 percent through early December, according to the Lipper High-Yield Bond Fund Index. Compared to the double-digit loss on the S&P 500 in the same period, these oft-derided bonds look downright fabulous.

But with the economy mired in recession and a high-yield bond default rate of 9.6 percent — and climbing — is it really a good time to be recommending high-yield investments?

Actually, yes, says David Hamilton, director of default research for Moody's Investor Services. Hamilton says the best returns on high-yields follow the peak in the default rates — which often occurs in the midst of a recession. “The correlation isn't always true,” he cautions, but, “it was true the last time.” Hamilton is referring to the time, after the last recession, when high-yield funds returned an average 37 percent in the 12 months following the peak in that cycle's default rate.

The million-dollar question: When will the default rate peak? It could top out in the first quarter, at about 11 percent, Hamilton reckons. By year's end, it will drop to a less scary 6 percent to 7 percent, he predicts. “Fundamental factors argue for it,” he says. First, the survivors of the debt-issuance bubble, which peaked in 1998 and has fueled this rise in defaults, will begin to play itself out. Add in an accommodative Federal Reserve and some sort of fiscal stimulus from Congress, and, Hamilton says, the pace of defaults will begin to abate.

But even when the peak in defaults materializes, no one should expect the kind of 30 percent plus returns of a decade ago. “This time is different,” says David Hinman, executive vice president of PIMCO's high-yield group in Newport Beach, Calif. Hinman isn't looking for a rerun of the 1990s rebound. The reason: This recession will not be as brief as the 1990 to 1991 recession. According to Hinman, capacity overhangs — which characterize the current recession — take much longer to correct (like years) than do inventory overhangs, which are corrected in a matter of quarters, as in the last recession.

Recovery Ahead?

So instead of a sharp rise, he foresees something more modest, with high-yield funds returning between 7 percent and 10 percent annually (total return plus coupon) over the next few years, better than the 5 percent to 6 percent that he thinks investment grade bonds will produce and similar to returns that will be earned on equities.

Kent Gasaway, the lead portfolio manager of the Buffalo High-Yield Fund, is a bit more optimistic about the potential recovery of junk. He has reason to be. His Mission, Kan.-based fund beat the odds last year; it was up 11 percent heading into December. Generally, though, he says, high-yields are tied to the economy. “If you believe that the economy will improve quarter by quarter as the year progresses [which he does], high yield will do well,” he says.

There are pitfalls, though. What worked for high-yield investors in 2001, according to Gasaway, was avoiding telecom issues — a black hole of defaults — and sticking to higher quality junk issues. “The funds that did well were those with increased exposure to higher quality bonds,” says Gasaway. Those bonds benefited more directly from the general decline in interest rates.

Gasaway thinks what will work in 2002 is increasing portfolio exposure to cyclically sensitive issuers, such as travel-related and tech companies. He expects the economy to improve by mid-year, and interest rates to rise in late 2002 — a trend that would hit higher quality bonds and narrow the spreads to his lower-quality holdings. “We could ultimately see negative returns in Treasurys and positive returns for high-yields — making 2002 the opposite of 2001,” says Gasaway.

But although Gasaway and Hinman predict that high-yields will perform much better in coming months, they don't expect an across-the-board resurgence. The funds that do well will be exposed to the right sectors sidestepping most of the defaults-yet-to-come. Telecom will continue to lead the way in defaults. High yield, in other words, isn't necessarily a no-brainer recommendation for an advisor. But the right high-yield fund could boost client accounts' performance over the next few years.

Junk Bonds? Or Not?

Searching for higher ground within the high-yield universe? These funds may provide it. Each carries a Morningstar category rating of 5 — which is a comparative ranking of how a fund has performed on a risk-adjusted basis relative to its peers. Each also has a below-average expense ratio.