Surprising Performance From High-Yield Bonds

Early in 2006, you couldn't find many positive prognostications about junk bonds. That includes in this space. I wasn't at all keen on junk bonds -- also known as high-yielding corporate bonds. My arguments for ignoring the category -- or at least not adding new money to it -- seemed logical. They included low yields relative to high-quality bonds, signs of a slowing economy, and better alternatives, such as energy pass-through securities and real estate investment trusts. The prospects of a weaker economy, in particular, affected my thinking. That's because slow growth or worse -- declining economic activity -- normally portends more bond defaults and rating downgrades.

Last year, according to Standard Poor's and Merrill Lynch, junk bonds returned 2.7% on average. That's total return, which includes income. Since these bonds are almost always issued at interest rates of 8% or higher, the typical high-yield bond (or bond fund) lost some principal value. You earned more from CDs, tax-exempt bonds, REITs and oil-and-gas income investments. I still like REITs and royalty trusts, although, because of price appreciation, their yields have dropped.

Getting back to junk, it turns out it hasn't done too badly this year. As of this week, Morningstar puts the average year-to-date return of junk-bond funds at 5.3%. That is net of fund expenses, so the bonds themselves have actually gained more. Lehman Brothers' U.S. high-yield index is up 6.7%. No domestic bond category even comes close. And junk has certainly performed far better in 2006 than the experts expected. SP, just to cite one forecaster, called for returns of 2% to 5% for the year. (The terms junk and high yield, by the way, generally refer to any bond rated below BBB by SP or Baa by Moody's.)

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All of the bogeymen that were supposed to weigh on junk this year have fled. The economy is slowing, but it's not headed for a recession. Interest rates have leveled off. Corporate profits have held up, especially in technology, where many junk bonds are hatched. The default rate on "speculative-grade" U.S. bonds was 2.4% a year ago. It's now 2.1%. It has been lower, but it's also been over 10%. The trend is comforting.

What now?

OK, once you absorb all this, should you throw a few darts at me, tell me I steered you away from an opportunity, and then rub it in by investing in a junk fund and telling me about it?

I think junk bonds deserve an upgrade, from avoid to neutral. My tepid endorsement stems from a close look into the particulars of the bond funds (the prudent way for most individuals to invest in junk) that have led the pack this year and those that trail. The higher-quality, more conservative junk funds have produced lower returns this year for the most part, while others with bigger weights in the riskiest bond classes have delivered the best results. Over a long cycle, it doesn't work this way. Instead, B-rated bonds usually outperform C-rated bonds. But in the second quarter of this year, for example, Summit High Yield fund said it earned 2.6% on its CCC-rated bonds but lost 0.4% on its BB-rated bonds.

Then again, I must say that I like some of the winners of this year's junk-fund sweepstakes.

Start with Aegis High Yield (symbol AHYFX). Its 8.9% return this year leads the pack. This is a tiny fund that has been available to the public only as of 2004. The Aegis funds are a tiny operation located in a corner of a mostly military office building in the Virginia suburbs of Washington, D.C. Aegis managers are known for buying stocks of distressed and recovering companies for their Aegis Value fund and take a similar approach with debt in the high-yield bond fund. Bill Berno, Aegis High Yield's manager, credits some good picks among distress cases (companies that are in or near bankruptcy) and staying away from treacherous industries, such as homebuilding and auto parts, for the strong results. Aegis is a gutsy buy if you're after a single junk fund: It requires a $10,000 investment and holds just $3 million in assets. Because the fund is so tiny, it holds just 18 bonds -- which is terribly concentrated for a junk fund. But I've met the Aegis people and feel comfortable that they know what they are doing. As they bring more money into this fund, they'll broaden the portfolio. Berno describes it as a conservative fund because he manages it for total return and not maximum yield. In fact, the fund's 6.7% yield is lower than that of such standard-bearers as the junk funds offered by Vanguard and T. Rowe Price.

Moving from the new to the established, we have Northeast Investors Trust (NTHEX). You could call this the granddaddy of junk-bond funds, or perhaps the income fund counterpart to Joe Paterno's Penn State football program. Ernest Monrad, who co-manages Northeast with his son Bruce, has the longest tenure of any high-yield fund manager by far. He's been at the fund since 1960 and Bruce since 1993. The fund dates to 1950. Its assets of $1.6 billion make it a giant in this category. The minimum investment is $1,000.

So far in 2006, Northeast has returned 7.8%, with a yield of 7.7%. Northeast's strong results over the years, and again in '06, are a testament to good research, low turnover of the bonds in the fund, and patience and experience. It has enough cash and time to wait for bonds that aren't working out to recover. The strategy this year has been to shorten up the maturity of its bonds to protect against rising interest rates. But the fund will take more risks if the managers feel such a move is appropriate. In any case, it's never a surprise to see Northeast Investors high in its category.

Nor is it a shock to see Westcore Flexible Income (WTLTX) riding high this year, with a return of 8.1% and a yield of 7.5%. It differs from the typical junk fund because it also invests in preferred stocks and some eclectic high-yielding securities, such as Thornburg Mortgage, technically a REIT, and Allied Capital, a lender to and investor in small businesses. Westcore, which is the brand name for the funds run by Denver Investment Advisors, has several experienced managers on this fund and, in general, tends to be ignored, perhaps unfairly, in discussions about decent no-load fund outfits.

Bottom line: Inflation and interest rates are under control, oil is down, economic growth is okay and junk bonds are leading the bond-fund race. I can't see that changing by the end of 2006.