Junk Bond Funds Take a Beating

Investors in high-yield corporate bonds received a rude reminder the past two months of why these bonds are called junk. After nearly five years of steady gains, the junk-bond market cracked as a result of concerns about subprime mortgages and general queasiness that too many investors had taken advantage of overly cheap money and borrowed more than they could safely handle. Junk bond mutual funds lost 3% in July alone.

Some called the resulting reaction a "liquidity crisis," suggesting that more and more lower-quality companies were finding it difficult, if not impossible, to sell their bonds. Oddly, this is occurring at a time when the default rate for high yield bonds is well below its historic average.

Northeast Investors is one fund that's kept its head respectably above water so far this year. Year to date through August 8, the fund returned 4.4%. That's four percentage points ahead of the Merrill Lynch US High Yield Master II index.

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Bruce Monrad, who runs the fund with his father, Ernest, describes himself as a junk-bond value investor. He likes debt from companies with dependable cash flow and hard assets, attributes that may buoy a bond's price in an environment of restricted access to cash.

Still, Northeast tumbled recently along with the rest of the junk-fund pack. The fund lost 4% from its May 11 high through its July 27 low, outperforming its benchmark index by more than one percentage point. Monrad attributes the fund's losses to investor sentiment rather than to any actual problems among issuers of the bonds it holds. He says Northeast's portfolio overlaps with those of many hedge funds, which have been selling junk bonds. That could be reason for pause, as more hedge-fund selling could be on the way.

Northeast's holdings are moderately aggressive. At last report, only 11% of the fund's $1.5 billion in assets were in bonds rated BB, the highest junk rating. B-rated bonds represented 44% of assets, and bonds rated below B or not rated at all accounted for 29%. The fund also had 10% of assets in stocks. The fund is 15% leveraged, meaning it has borrowed 15% of its assets. Monrad says he generally uses the spare cash to meet investor redemptions (which have totaled about 10% of assets over the past two months) or to buy attractive bonds without having to sell other holdings.

Northeast has performed solidly over the long term. The fund returned 8.3% annualized since Bruce Monrad joined the fund in 1993 through July 31. That beat the average junk-bond fund by 1.4 percentage points per year. But over the past five years, the fund's 9.0% annualized return trails the average junk fund by an average of 1.5 percentage points per year. Northeast (symbol NTHEX; 800-225-6704) charges 1.23% in annual expenses, part of which pays for the cost of interest for leveraging.