Junk investors contemplate the future

Junk bond owners' only consolation about 2005 is that things could have been worse.

Investors in the average corporate junk bond mutual fund last year earned a total return of 2.5 per cent, which was interest income minus principal loss, according to Morningstar Inc.

That doesn't sound like a "high yield" investment and a high yield, of course, is the whole point of owning junk bonds, those relatively speculative company IOUs that have become popular with many individual investors over the last 15 years.

The question now is whether the junk sector is headed for a rebound this year or whether it has begun a period similar to 1998 to 2002, when buy-and-hold investors in the securities actually lost money over five years.

A nagging concern is that, with the steep decline in most interest rates worldwide since 2002, investors simply aren't being paid enough for the risk they're taking in junk issues or even in higher-quality bonds.

Junk bond optimists, however, expect the sector to get back to doing what it's supposed to do, which is to provide investors with a return significantly better than what they could earn on Treasury bonds or other investment-grade securities.

Junk bonds are all of those considered below investment grade, and there are lots of them $840 billion outstanding in the US, from companies as disparate as Chiquita Brands International Inc, JC Penney Co and Royal Caribbean Cruises Ltd.

The bullish case for junk is that the economy is healthy and will continue to grow fast enough so that few junk-issuing companies will have trouble making their debt payments. This case also assumes that market interest rates won't rise significantly from current levels.

A levelling off of interest rates in a strong economy could allow junk investors to collect decent yields without worrying about principal loss.

But to perform well for investors, the junk market also must avoid the kind of big scare that hit it in 2005.

Fear that General Motors Corp would file for bankruptcy protection helped trigger a sharp run-up in junk bond yields last spring, as investors began to question whether a host of debt-heavy companies might end up defaulting on their bonds.

GM still is solvent, but the junk market never fully got over the fright. The average yield on an index of 100 junk issues tracked by KDP Investment Advisors rocketed from 6.5 per cent in February to 8.1 per cent by mid-May. It fell back to 7 per cent in summer, then rose again in fall and now sits at about 7.6 per cent.

And that's what clipped junk bond mutual fund returns in 2005. As market interest rates rise, the value of older, lower-yielding bonds declines. So even though junk fund owners may have earned interest income equivalent to a yield of 6 per cent or more for the year, the principal loss they suffered on their fund shares left them with a total return of just 2.5 per cent on average.

By contrast, when the junk bond market is healthy, the annual total returns can easily be in the double digits. That was the case in 2004, when the average junk fund gained 10 per cent, according to Morningstar.

Junk bond bulls insist that it's highly unlikely the market will face a surge in defaults this year.

"The default rate will tick up, but we don't see a systemic increase," said Michael Rob-erge, chief fixed income officer at mutual fund firm MFS Investment Management in Boston.

His optimism, he says, is rooted in the fact that money still is relatively easy. It's when the corporate financing window slams shut that the junk market reels. "We are nowhere near a period when credit is not going to be available to companies," Roberge said.

The problem today, some bond pros say, is that even though junk yields are up from a year ago, they aren't enough to compensate for the trouble that may loom down the road for many junk-issuing companies maybe not in 2006, but in 2007 or 2008. We don't see much value in the corporate market," said Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles.

What's more, bond investors increasingly are feeling like steerage passengers compared with equity investors. Many companies are buying back record amounts of stock to please shareholders (including hedge fund activists) who are clamouring for higher share prices.