Junk-bond chasers eye yields, downplay risks

Maybe it's a need for more income among investors tired of tiny-to-negative total returns from their mutual funds. Or maybe people are focusing on past performance.

Whatever the reason, investors seem to have embraced risk in 2003, and nowhere is this more apparent than in the rush to invest in high-yield-bond mutual funds.

High-yield (or "junk") bond funds had pulled in more than $21 billion by June 25 this year, according to AMG Data Resources in Arcata, Calif. That beats the previous record of $17.85 billion for all of 1997.

So far, these funds haven't disappointed. For the three months ended June 30, the average high-yield bond fund returned 8.9 percent, according to Morningstar Inc. in Chicago. So far this year, the average return from these funds was 14.3 percent, and the 12-month return was 17 percent.

Unlike funds that invest in US Treasury securities, municipal bonds, or high-grade corporate bonds, junk-bond funds concentrate on lower-rated corporate bonds. These bonds are rated Ba or below by Moody's Investors Service, Inc., or BB or below by Standard & Poor's Corp. Unrated bonds may also be included.

The rush into high-yield bond funds began in earnest last year, mainly as a way to replace some of the income lost from lower-yielding government and corporate bonds and bond funds. Now, investors are paying attention to total return, too.

"It may have started as a yield chase last fall," says Morningstar analyst Scott Barry. "We saw a lot of funds yielding 10 or 12 percent. Then, as total returns started to pick up, I think it became more of a total-return chase. Investors started to see a number of these funds with 8, 10, and 12 percent total returns and just piled on."

Also, as the economy improves, corporate defaults - an important measure of the strength of the high-yield market - are coming down, notes Martin Vostry, a research analyst at Lipper Analytical Services.

"So the default risk of these funds is declining as well, even though the economic recovery has not been as swift as some people may have hoped," he says. "The fact that more companies are able to refinance their debt at lower interest rates means they are defaulting less on their loans. I think that's a boon for the market as a whole."

In spite of the strong performance of these funds, they should still be handled with great care, analysts say. "If people are trying to get the same rate they got from Treasuries four years ago, they should know that there's definitely a big risk" in trying to do so with high-yield bonds, Mr. Vostry says.

For one thing, although the default rate in the high-yield market has improved, it would only take a couple of high-profile defaults or scandals - such as Enron or Adelphia Communications - to shake the confidence of investors in this market.

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