Junk Can Beat Stocks, but Nadir Is Still to Come

After a strong rally in May, June and July, junk bonds lately have been doing what they’ve done best since 1988: lose value. But maybe not as much as you think.

Recession worries and rising defaults caused First Boston Corp.’s index of total returns for corporate junk bonds to plunge 7.6% in September after a 4.6% fall in August.

Junk bond mutual funds, the way most individuals own such bonds, have likewise been crunched. But junk fund shareholders who assume they’re losing their shirts (or maybe their entire wardrobe) should get out their pencils and check their funds’ standings:

* Despite all the bad news this year, the First Boston index was off just 6.7% this year through the end of September. Many junk bond funds have lost less than that.

* In contrast, the average general stock mutual fund was off 12.7% in the first nine months. So as lousy as junk has been, stocks are doing worse.

What’s happening is that the high yields that healthy junk bonds are paying have substantially offset the losses on defaulted bonds--as well as the drop in bond principal values that stems from fear of future defaults.

That’s what “total return” is: Interest plus or minus principal change. It’s the way junk bonds are supposed to work. You’re paid 13%-plus annual interest to compensate for the higher risk to your principal. Even as $16 billion in junk bonds have defaulted this year, most of the companies in the estimated $330-billion junk universe continue to pay interest as promised.

Still, a loss is a loss, and most junk funds are in the red. Though investors who have owned the funds since the late 1980s may not be down as much as they fear, the only pertinent question now is, what’s next? Will you make any money in junk soon, or should you just say sayonara ?

Wall Street is in virtual unanimous agreement that many more debt-laden companies will default on their junk bonds in the years ahead, recession or no. What’s more, insurance companies are increasingly being pressured by state regulators to sell their lowest-quality junk. And the savings and loan industry still has a huge pile to sell (witness Columbia Savings’ renewed attempts to peddle its $2.9-billion portfolio).

All that means the odds are heavily against a sharp rise in junk bond values soon. In fact, Joseph Bencivenga, high-yield research chief at Salomon Bros. in New York, puts it bluntly: “This market won’t be bottoming out for four years.”

The junk mutual funds must believe that because more of them are beginning to talk about the “long-term appreciation potential” of the funds rather than emphasizing high current returns. Translation: After the market shakes out all the bad credits over the next two to three years, the good bonds should soar in value and your total return should soar as well. If you can wait.

That’s what Fidelity Investments is trying to pitch to holders of its giant High Income junk fund. Fidelity last week announced that it wants to shift more of the $1.1-billion fund’s assets to a capital-appreciation focus.

But Howard S. Marks, high-yield portfolio chief at Trust Co. of the West in Los Angeles, thinks that there is a little too much talk about junk bond capital appreciation these days. That sounds to him like “the resort of someone whose securities have turned into non-payers,” he says. He buys junk bonds for one reason: They pay high yields. His goal is to avoid default candidates so that he doesn’t have to concern himself with which bonds may or may not come back from the dead.

Indeed, the junk fund managers who early on decided to dump the dogs are in the best shape now.

Dave Halfpap, who runs the $33-million Mid-America High Yield fund in Cedar Rapids, Iowa, has just 45% of his assets in junk bonds. The rest is investment-grade bonds. That means he’s earning a lower yield--about 10.8%--but it also means Halfpap has avoided the sharp losses of other fund managers. In the year to date, his fund’s total return is a positive 1.8%; last year he earned 12.3%. Now, Halfpap feels that he’s in a good position to pick up tremendously depressed junk bonds that he believes that will survive any recession.

Many other junk managers aren’t so lucky. And the way the outlook is stacked against the junkiest junk, the laggard bond funds during the past two years may face the toughest going in the years ahead as well.

So if you don’t feel like waiting another two or three years to start making money again, selling your junk now may be a smart move. You can earn 7.5% just sitting in a money-market fund. When the junk market does bottom, there will be plenty of money to be made on the upside. But the bottom seems a long way off.

A final note: If you aren’t sure what your junk fund’s total return has been so far this year or what it was in 1989, call the fund. You can’t figure it from the prices quoted in mutual fund tables, because those figures don’t account for interest earned. Make sure the fund understands you’re asking for total return, not the interest yield.

JUNK BOND FUND SCORECARD Though junk bond prices have fallen sharply in recent weeks, many junk bond mutual funds have lost less than the average stock fund so far this year. How a sampling of funds fared last year and through the third quarter of this year:

Total investment return Bond fund 1989 Yr.-to-date* Mid-America High Yield +12.3% +1.8% Oppenheimer High Yield +3.9% -1.2% American High Income +5.6% -1.7% Fidelity High Income -3.2% -2.4% Vanguard High Yield +1.9% -6.6% Pru-Bache High Yield -1.4% -7.8% Pacific Horizon High Yield -5.2% -14.4% Dean Witter High Yield -13.6% -18.2% Junk bond index +0.4% -6.7% Avg. general stock fund +24.0% -12.7%

* Data through Sept. 27

Source: Lipper Analytical Services Inc., First Boston Corp.