``Junk bonds'' and junk-bond mutual funds have a kind of reverse snob appeal these days. If you've been keeping up with the merger frenzy that has gripped American business, you know that high-yield, high-risk corporate bonds -- unflatteringly known as ``junk bonds'' -- are all the rage in the financing of mergers, hostile takeovers, and leveraged buyouts.
Junk bonds are controversial. The Federal Reserve had made noises about disallowing them in takeover attempts. They are blamed for skyrocketing corporate debt and the deterioration of American industry's creditworthiness.
Although junk bonds have a kind of bad-boy appeal, they are not just things for financial pirates to get into. High-yield bonds are also issued by the ``fallen angels'' -- meaning companies which have illustrious pasts but current financial problems. International Harvester (now Navistar) and Control Data Corporation are two examples of fallen angels.
Moreover, ``rising stars'' -- those companies that on their way up but are not yet deemed sound credit risks by Moody's or Standard & Poor's -- also issue bonds that have relatively high yields and relatively lower ratings.
The main reason junk bonds and junk-bond mutual funds are popular is that the rate of return is exceptionally high for a debt instrument these days. During 1985, the assets of high-yield bond funds almost doubled, to $14 billion.
The insurance industry, too, has jumped on junk bonds, offering high-yield portfolios attached to variable life insurance policies. Because of the insurance connection, some of the risk is mitigated, and taxes are deferred.
The caveat: There could be defaults or bankruptcies on some of the bonds in any of these funds. That can hurt the yield. And the bonds are ``callable'' at any time. A massive refinancing wave due to lower interest rates could reduce the yield.
Still, junk-bond funds are yielding 3 percent or more above US Treasury bills these days, and they are likely to maintain that spread even if they march down somewhat over the next year.
This puts them around 10 percent, which is quite an attractive rate for people who have watched the yields on their money market mutual funds fall.
If you want to get into junk bonds, there is no doubt that the safest way is to be widely diversified. For the individual investor, this can best be done by going into a high-yield bond fund.
The top five high-yield corporate bond funds over the past year (as of April, tracked by the Schabaker Investment Management in Gaithersburg, Md.) were Putnam High Yield Trust I, with a 12.84 percent yield; Oppenheimer High Yield Fund at 12.79 percent; Bull & Bear High Yield Fund, 12.64; PaineWebber High Yield Trust, 12.48; and Vanguard Fixed Income High Yield Fund, 12.32.
The yields are down only fractionally from March, which indicates how well these funds have been maintaining an investor's income at a time of falling interest rates. But fund managers say they do expect yields to decline over the next year, since bond will be offering lower interest rates.
Thus, some high-yield bond funds are closing their doors to new investors to maintain current yields. League-leading Putnam, for instance, has just begun Putnam High Yield Trust II. Felix A. Smith, manager of both of Putnam's high-yield funds, says he expects about a 10 or 10 percent return on his new fund, as opposed to the 12-plus percent on the old one. Managing the risk
How exactly do you buy good junk?
Mr. Smith says his No. 1 fund takes a balanced approach, putting 25 percent of assets in investment-grade corporate bonds (rated triple-B or better) and 75 percent in bonds that reach as low as a single B rating. He calls these as ``an amalgam of credits regarded as more speculative in nature and for which you get rewarded with a high yield.''
To guard against defaults from companies teetering on the brink of bankruptcy, Smith says, constant vigilance is needed.
Action must be taken very quickly to dump a bond in danger of going bad before all the other bondholders do the same thing. Smith monitors working-capital ratios and cash flows at the corporations that issue these bonds.
As a result, the default rate of bonds in his fund has been zero, although ``you might take a haircut in a situation or two.''
Still, no one knows what might happen during a recession to these junk bonds. A study by New York University finance professor Edward Altman, commissioned by Morgan Stanley & Co., shows that between 1974 and '84 the default rate on high-yield bonds averaged only 1.5 percent per year. But during the 1982 recession, the rate shot up to 4 percent.
Since high-yield bond funds are a relatively recent phenomenon -- and since most mutual fund investors should be thinking about the long run -- it pays to be careful lest a future recession cause damage to the portfolio.
There are 150 issues in Putnam High Yield Trust I, 100,000 shareholders, and some $2.4 billion in assets. To get an idea of its popularity, the Putnam fund began life in 1978 with $45 million in its coffers. By 1985 it had gained $1 billion in assets. Between 1985 and the present it chalked up another $1 billion.
But Smith figures the use of junk bonds to finance corporate mergers and acquisitions will begin to wane now, since stock prices are at such heights that there are few bargain acquisitions left. He thinks one of the key financial growth areas over the next year, however, will be equity and bond combinations, such as convertible bonds. Treasuries plus 3 percent
Noting the Altman study of junk-bond defaults, Tom O'Donnell, who runs the Seligman High Yield Bond Series, says the keys to a high-yield bond fund are diversification and a management style that treats these bonds just like ``equities with a coupon.''
In other words, the stock market research that Seligman does for its equity investments is applied to these bonds, so that Mr. O'Donnell and his colleagues can be sure the companies are not near default or bankruptcy.
The Seligman portfolio has about 45 bond issues in it, but O'Donnell says 125 issues are closely tracked and bonds are selected from that list.
He describes the companies as ``predominantly rising stars'' and contends that with an ``activist'' portfolio management, this sort of fund may be safer than one that passively purchases investment-grade bonds ranked by credit agencies.
O'Donnell notes that the activist approach is also important, because of the callable nature of corporate bonds. By monitoring the new-issue and secondary-bond markets, he says, he can determine if a bond is about to ``run out of gas'' and be called or refunded.
This Seligman fund has just completed its first year in operation, during which assets rose from about $300,000 in seed money to $46.5 million by March 31. With an 11.84 percent yield (12.5 percent compounded), it was ranked No. 4 for total return by Lipper Analytical Services.
Even with lower interest rates, O'Donnell says, it should be no problem to maintain the fund's yield, which is about 3 percent above Treasury bills. Moreover, with interest rates falling, the bonds in the fund have a better possibility of capital appreciation.