Sun, Sep 01, 2002 page10

• Junk bonds may make a comeback

  LOOKING FOR LIFT With interest rates down and the US stock market continuing to trick investors, some say the time to switch to junk may be about to arrive

  • NY TIMES NEWS SERVICE
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  By a number of measures, junk bonds are having their worst year in a decade, as the bankruptcies of WorldCom, Adelphia Communica-tions and a host of other companies have driven many risk-averse investors away from the sector.

  But for those who can accept substantial risk, junk bonds -- more formally known as high-yield bonds -- could deliver formidable returns in the next 12 months, say some economists, fund managers and credit analysts.

  

  Jack V. Malvey of Lehman Brothers said he and others erred in predicting a junk-bond rebound early at the start of the year. Malvey in his Manhattan office last week.

  PHOTO: NY TIMES

  "At some point, the junk-bond sector is going to turn, and it is going to turn very positively," said Edward I. Altman, a finance professor at New York University's Stern School of Business. "The question is when. I would say probably soon after the default rates peak, and that has happened, I suspect."

  Altman has devised a widely used method for predicting when companies are likely to default, or become unable to pay interest on their bonds.

  Junk-bond prices have fallen 6 percent this year through Thursday, according to the Merrill Lynch Master High Yield Index. That is their worst record since 1990, when the index fell 4.4 percent for the year. Because prices and yields move in opposite directions, junk-bond yields have soared, to an average of 12.7 percent, according to Moody's Investors Service, 8.9 percentage points higher than the 10-year Treasury note.

  Default rates on junk bonds peaked at 10.7 percent in January and were at 10.1 percent in July, according to Moody's. The last time rates jumped to such levels was in June 1991, when they hit 12.8 percent. The agency's calculation measures the percentage of defaulting companies out of all American corporate bond issuers, while Altman looks at the total dollar value of nonperforming debt. His calculations show a default rate of 11.3 percent in July; it is likely to surpass 12 percent this month.

  The rate of corporate defaults is closely linked to the economy. When the economy improves, the default rate would be expected to decline, with prices rising and yields falling. An investor who could time this move would earn substantial profits, and some risk takers have begun to return to the sector. Moody's has predicted that default rates will dip to 9 percent by year-end and to 8.5 percent by July 2003.

  "Because of these attractive yields and the lack of other options out there to get a decent return, this asset class has taken in a huge chunk of money recently," said Sandy R. Rufenacht, manager of the Janus High-Yield fund in Denver. Investors are hoping for a rebound rivaling that of 1991, when junk-bond prices rocketed 34.6 percent, according to the Master High Yield Index.

  Still, some people say the current risks outweigh potential gains. "Now is not a good time because I think we are still a few months away from the bottom of the equities market," and junk bonds could fall further, said Peter J. Petas, chief global strategist at CreditSights, an independent research firm in New York.

  Unforeseen circumstances

  The string of accounting scandals since spring erased the modest gains that junk bonds made earlier in the year. The debt of companies like WorldCom, Tyco International and Qwest Communications ranked as investment grade. When these bonds collapsed, investor anxiety spread to the junk sector, sending prices lower.

  Mark J. Vaselkiv, president of the T. Rowe Price High Yield fund, said WorldCom bonds, at 0.25 percent of the fund's assets, eroded his performance by two-tenths of a percentage point for the year. He recently sold the bond at 12 cents on the dollar, down from the 45 cents he paid in mid-May.

  "Everything came crashing down in June with the WorldCom debacle," Vaselkiv said.

  He said he sold his fund's holdings of the senior bonds of Adelphia, the cable operator, at US$0.90 on the dollar in April; he bought them at par, 100 cents on the dollar, in 1999; they have since dropped to US$0.35.

  Vaselkiv has bought issues that have climbed in value, including bonds of Nextel Communications, at US$0.725 on the dollar in May; the price is now US$0.755. Tyco's senior debt, also bought that month at US$0.77, has climbed to US$0.83. The fund is down 1.1 percent this year through Thursday; it has returned 1.2 percent to investors, annualized, over the last three years, according to Morningstar Inc.

  In terms of risk, said Rufenacht at Janus, high-yield bonds have much in common with stocks. Holders of junk bonds have little protection if an issuer runs into financial difficulties.

  "If the value in a company's equity is eroding, well that is the cushion underneath the high-yield market, and high-yield bonds will be next," he said.

  Not so high-yield

  In the last three years, Janus High-Yield has returned 3.5 percent annualized, though it was down 0.2 percent for this year through Thursday. That compares with an average decline of 5.8 percent for Morningstar's index of 361 high-yield funds.

  Bond prices of wireless companies like Nextel hurt the fund this year, he said, but those issues have come back in the last month. Although Rufenacht has held on to Nextel, the fund is now primarily invested in issues he regards as only moderately risky, like those of casino, lodging, energy, health care and home building companies.

  Because of the volatility of the sector, investors would be wise to buy a high-yield mutual fund rather than individual junk bonds, said David Wyss, chief economist at Standard & Poor's. "Even the ordinary millionaire doesn't have enough money to just pick junk bonds and diversify," he said.

  High-yield bonds became widely used in the late 1980s, in part because of the efforts of Michael R. Milken and his firm, Drexel Burnham Lambert, which dominated the sector. But prices crashed in 1990, forcing Drexel into bankruptcy. Milken went to prison on a securities fraud conviction. A year later, though, the sector rose sharply in value, and it performed well on an annualized basis until late 1997.

  Since then, prices of junk bonds have fallen about 0.2 percent, annualized, according to the Master High Yield Index.

  The collapse of technology and telecommunications stocks sent prices of junk bonds lower in 2000 and last year. That is what persuaded Thomas P. Huggins, co-manager of the Eaton Vance Income Fund of Boston, to buy more highly rated junk debt in sectors like casinos and health care, as well as consumer goods.

  Huggins still sees growth potential, though, in certain media company issues. He said senior notes of Cablevision Inc that mature in April 2011 and have a 7| percent interest coupon are now trading at US$0.825 on the dollar, up from a low of US$0.70 on Aug. 7; he expects the price to rise further.

  Slippage

  His fund is down 6.1 percent for the year and down 6.2 percent, annualized, for the last three years, according to Morningstar.

  Jack V. Malvey, chief global fixed-income strategist at Lehman Brothers, said he and others on Wall Street mistakenly predicted a rebound in the junk bond sector at the start of the year. "Our prognostications were not correct," Malvey acknowledged. Still, he said, "this would be a good period to consider shopping in the high-yield market."

  John E. Puchalla, senior economist at Moody's, played down the risk of higher default rates and further accounting scandals, saying that much of that risk is already reflected in yields. "Premiums are already extremely wide relative to historical averages," Puchalla said.

  "We've already seen some firming of earnings, so we would expect favorable returns on speculative bonds in the next year."
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