Cash in Hand
Don't Overload on Junk Bonds for Income
By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance
June 17, 2002
While I agree that junk bonds seem poised for a rally, there's a related question that Steve didn't address: Are junk bond funds right for an income-dependent portfolio?
It's one thing to forecast that the total returns of junk bonds will beat those of, say, medium-term Treasuries (not to mention stocks). It's a different matter to advise investors who live on dividends and interest to trust their capital here.
Easy does it
The big picture for junk bond prices in 2002 and probably 2003 is bright because in the past, economic recoveries have been excellent for junk bonds' market values. In a strengthening economy, junk bond prices rise and yields fall, since prices move inversely to yields. So the yield spread (the margin of extra interest income) will narrow between high-yield bonds and less volatile alternatives.
That means it's fine to own junk funds if you already do and you hope to recover some losses; or if you're searching everywhere for capital gains and any income is a bonus.
But if you're an income investor, ask a financial planner how much junk you really should own. I suspect he or she will tell you maybe 10% max.
Payouts are dwindling
Why such a miserly allocation? Because some of the best-run high-yield funds are already reducing their income payouts. Northeast Investors (NTHEX), one of the oldest and most reliable junk funds, pays dividends quarterly. In August and November, the distribution was 21 cents a share. In February it was 18 cents. In May, 15 cents.
Northeast's net-asset value today is $7.65, so if you take that 15 cents and call it 60 cents for the year, you get a 7.8% yield. (The fund's total return for the year to date, which is the combination of interest income and the rise in the value of its holdings, is already 7%.)
As the income element slides, junk bond funds come under even more pressure to have a good year on the capital-growth side so investors can collect a respectable yield and maintain their principal. Since 1997, many junk funds' net-asset values have fallen by half or so, and investors have had enough of that.
As a result, more and more of the high-yield issues fund managers are able to buy (or are willing to buy) are higher-grade junk, mainly bonds rated BB by Standard & Poor's or Ba2 by Moody's with coupon rates of 8% to 9%. Funds have become reluctant to gamble on the C-rated stuff, the bonds that are coming to market with yields like 11%.
So expect gradually lower dividend rates. Junk bonds will always be a few percentage points higher than Treasuries, but not so high that you should abandon all caution and gorge on the stuff.
