Junk bond funds draw cash, but the risks remain

NEW YORK -- Stung by the stock market's volatility, investors are pouring record amounts of cash into high-yield junk bond funds. While advisers say these funds may offer short-term promise, they caution investors against blindly seeking higher returns without gauging the risks.

Junk bond funds invest in corporate bonds with low credit ratings; because of the higher risk of default, they pay much higher yields than Treasury bonds, whose returns have been pressured recently in anticipation of a rise in interest rates.

Investors have responded to the higher yields, pushing junk bond inflows to a record $10.5 billion in the first quarter, up from $5.8 billion in the year-ago period. That figure also comes close to surpassing the $11.7 billion seen in all of 2002, according to AMG Data Services.

'A moderate economy'

Analysts say that may be a good sign, indicating growing investor confidence in companies' balance sheets after a year of accounting scandals in 2002. But investors also may be chasing high returns without understanding that a credit default could result in substantial losses.

"The interest is being prompted by general feelings that we'll have a moderate economy -- making stocks less attractive -- and the general low yields for safe instruments such as Treasuries," said Andrew Clark, senior research analyst at fund tracker Lipper Inc.

"But the high-yields tend to be highly volatile themselves," he said. "It's the kind of fund purchase that we believe bears watching at least once a quarter."

Junk bonds often do well in harder economic times toward the end of a recession, as investors bet that corporations will work on reducing debt -- making them less of a credit risk -- rather than boosting earnings, which drive up stock prices.

Indeed, junk bond yields currently range from about 7 percent to 9 percent, compared with about 3 percent to 4 percent for government intermediate bonds and 1 percent or less for money market funds. Junk bonds also are less susceptible to rising interest rates, which have pressured Treasury yields, because their high-coupon payments cushion losses in principal.

In the meantime, mutual funds investing in junk bonds notched a 6.8 percent return so far this year, compared with 2.32 percent for the average taxable fixed income fund and a 1.2 percent negative return for the average equity fund, according to Lipper.

Still, risks remain. A resurgent economy later this year would make stocks a safer and better-performing alternative than junk bonds, while if there's a double-dip recession, that could lead to a spike in credit defaults, making Treasuries the better bet.

And of course, in the event of a default, investors typically lose most, if not all, of their capital in that company, although investment in a junk fund softens the impact by investing money in many businesses.

'The question is how long'

David Hamilton, director of default research at Moody's Investor Service, said the rally in junk bonds is comparable to what was seen in the early 1990s, when the economy was pulling out of recession and junk returns surged. But investors may be wrongly expecting a repeat performance this year, he said.

"The falloff in the default rate has not been as steep as a decade ago," Hamilton said. "We're still expecting the default rate to fall, the question is how long it's going to take."

Advisers suggest that investors might consider devoting 5 percent of their portfolio to junk bonds if they invest in a diversified fund and review their holdings on a regular basis.

The telecom and technology sectors remain riskier investments, with default rates higher than other areas, while consumer staples, healthcare and energy look more promising, they said.

"If you revisit the fund every three months, it's probably an excellent move," Lipper's Clark said. "But if you're someone who reviews every few years, you could be stepping into a very deep puddle."

Michael W. Boone, a certified financial planner in Bellevue, Wash., agreed.

"Investors need to understand that high-yield bonds aren't simply government bonds that pay twice as much," he said. "There's a big difference in default risk, and any shock to the equity markets will have an impact on high-yield markets."

On the Net

www.lipperweb.com

www.amgdata.com

www.moodys.com