Junk Funds Clean Up Their Reputation

There's money to be made in junk.

Junk bond funds are not something you threw out with yesterday's garbage. Not if you're financially savvy, anyway.

These mutual funds may be risky, but they've paid investors well - often giving double-digit returns even in the low-interest-rate 1990s.

That, plus the fact that no self-respecting mutual fund wants to be associated with "junk," resulted in a more upbeat name for these funds: "high-yield."

Still, there's debate about whether now is a good time to buy. Popularity has driven their prices up and yields down, closer to rates paid by traditional, less risky bonds.

High-yield bond funds invest in corporate debt that carries a low credit rating, below "investment grade" in financial jargon. The lower rating of junk bonds means they must pay higher interest.

The bonds are generally issued by financially struggling companies or newer firms that lack the operating history to earn a higher credit rating.

The market is much healthier today than in the 1980s, when it was dominated by junk-bond pioneer Michael Milken, and the bonds were often used to finance takeovers.

Risk-return equation

Still, about 3.5 percent of these bonds default. So investors deserve their extra income.

And they may not be getting enough of it.

Junk bonds now yield only about three percentage points more than ultrasafe US Treasury bonds. In the past, that spread has been twice as wide.

Federal Reserve chairman Alan Greenspan warned in March that both stocks and high-yield bonds were "overvalued." The remarks sparked a brief downturn for junk bonds.

But many experts say these bonds hold promise, even at current prices.

Sheldon Jacobs, who publishes the No-Load Fund Investor in Irvington-on-Hudson, N.Y., notes that high-yield funds typically fall less in market downturns than the average diversified stock fund.

In the market crash of 1987, junk funds fell 4 percent, versus 21 percent for stock funds. In the third quarter of 1990, junk bond funds fell 3 percent, compared with almost 17 percent for stock funds.

In a deep recession, Mr. Jacobs warns, returns could plummet as defaults surge.

Junk funds can serve two functions when you plan the stock/bond mix of your portfolio.

Jacobs sees them as the equivalent of a stock fund. Other analysts favor using them to spice up your bond, or fixed-income, mix.

Either way, financial advisers say a high-yield fund adds useful diversification to your portfolio: less risk than stocks, but higher returns than most bonds.

Picking a high-yield fund

Jacobs suggests putting 5 to 10 percent of your money in these funds.

In choosing a high-yield bond fund, experts offer the following guidelines:

* Look for a low or zero default rate.

* Don't shop just for yield. Focus on total return. A higher total return over two or three years indicates a better-managed fund.

* Be wary of funds that juice up their returns with especially risky assets, such as high-yielding debt from developing nations.

* Look for portfolios with high credit quality. (Bonds rated below B are considered speculative.)

One standout has been the Seligman High-Yield Bond A (800-221-2783). It has posted average returns of 13.2 percent over the past five years. This year, it's up about 3 percent - on par with most high-yield funds.

Portfolio manager Daniel Charleston also notes his default-free record since 1991.

His portfolio is somewhat typical of high-yield funds: Top sectors are cable television, 14 percent; gaming and hotels, 12 percent; telecommunications, 11 percent; broadcasting, 7 percent; and cellular systems, 4.4 percent.

Other top high-yield funds, measured by five-year performance, include Northeast Investors (14.6 percent; 800-225-6704), Fidelity Spartan High Income (13.9 percent; 800-544-8888), MainStay High Yield Corporate Bond B (13.7 percent; 800-522-4202) and Phoenix High Yield A (11.8 percent; 800-243-4361).

One alternative to junk bonds is to buy a high-income municipal bond fund.

These offer hefty current income with freedom from federal taxes. Credit ratings also tend to be slightly higher than for junk bond funds.

Case in point: the Evergreen Florida High Income Municipal Bond Fund (800-807-2940.) For the three years ending April 20, it returned 8.17 percent. Similar funds returned an average 6.43 percent, according to Lipper Analytical Services.