Junk bond returns may be in double digits before too long.
After five years of flat or negative returns, high-yield bond fund managers expect that their funds will at least earn their coupons, which are about 9%, this year. But total returns could soar into the double digits when the economy improves, and for yield-hungry investors that could turn out to be a once-in-a-decade opportunity.
Over the past three years, high-yield bond funds have performed about midway between stocks and investment-grade corporate bonds. The average high-yield bond fund lost 2.8% annually in the three years ending December 31, 2002, according to Morningstar Inc., Chicago. By contrast, the Lehman Brothers Aggregate bond index grew at a 10% annual rate and the S&P 500 lost 14.6% annually.
On a positive note, high-yield bonds have acted independently of both the stock and bond markets. High-yield bond funds sported an R square of 0.28 to the S&P 500 and 0.18 to the Lehman Brothers Aggregate Bond index. Only a small portion of the volatility of either the equity or bond market contributed to the volatility of the high-yield market.
"High-yield bonds are a beast unto themselves," says Mark Durbiano, manager of the Federated High-Yield Trust. "The meltdown in equities over the past few years hasn't affected high-yield bonds all that badly. High-yield bonds have low correlations. But they may take their cue from the equity or bond markets."
A sluggish economy and a record number of bond defaults contributed to the 2002 malaise. Last year, a number of investment-grade credits, such as Tyco, Qwest, WorldCom and Georgia Pacific, became junk bonds.
High-yield issuers remain highly leveraged. In the past, they reduced debt by issuing stock. But that hasn't been an option over the past few years because the demand for initial public stock offerings has dwindled. Banks cut their lending. And many companies with capital expenditures had trouble servicing their debts.
Defaults on high-yield bonds were more than 12% in 2002. This year, the default rate has dwindled to 8%, according to Moody's Investors Service, New York. That's still double its historical average of 4%.
Today, however, fund managers say the excess has been squeezed from the market. The default rate is declining. Many companies have cut costs and strengthened their balance sheets.
The big question is when will the economy and stock market head north? Margaret Patel, manager of the Pioneer High-Yield Fund, estimates that high-yield bonds could register a total return of around 10% this year, but a lot depends on how the economy performs. If the economy grows and consumer spending picks up steam, high-yield bonds should perform well. "The atmosphere is one of fairly muted growth, not dynamic sector growth," Patel says. "The best high-yield companies are ones with stable operations, modestly increasing revenues and reasonable liquidity on the balance sheet."
She adds that we might have to wait until mid-year when Uncle Sam's economic stimulus and the tax cut kick in. Patel owns companies that are leaders in stable, expanding industries. They must have unique products and stronger balance sheets and cash flow than their peers. The companies show moderately increasing revenues and cash on the books, a critical indicator in an arena where the biggest fear is running out of cash.