Lipper Research Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN
Tuesday, June 14, 2005
Q. Don, with long-term interest rates still low, might investors lookingfor yield want to consider high-yield bond funds?A. Well, that is a very interesting question! There are several pros andcons.
Q. And of course "high-yield" is polite Wall Street-ese for "Junk Bonds,"right?
A. Definitely. Investors have a very strong tendency to focus on theperceived rewards or returns, and not to hear or to fully consider therisks. This is equally true in the income-investing area, where the juciercash yield itself is a very strong lure.
Q. How can an investor tell whether junk bonds (and funds) are paying themenough for the risks involved?
A. You put that question very well, and to me that is a central issue thatis often overlooked. Typically, sophisticated bond investors look at theyield "spread" (or difference) in low-quality versus U.S. Governmentyields. That spread cycles up and down depending on default rates andoverall economic conditions and expectations.
Q. What is the spread now?
A. About 4%... and it was as much as 10 or 11 yield points during theworst of the last recession. But it got down to under 2.5% earlier thisyear. Almost 5% is a typical historical average.
Q. What is currently affecting the prevailing yield spread?
A. Well, default rates are presently very low, so that lowers yield sincelow risk is perceived. Yields on quality paper are low, so some investorsare stretching for the yield they want or "need," and such buying is alsokeeping the spread low. But the Fed is clearly signaling it is raisingrates -- and that eventually will catch up with the economy and put thebrakes on, so that is a concern that has raised the spread. And veryrecently the drops of GM and Ford to junk-bond status caused some sellingand re-shuffling in portfolios, which raised yields a bit.
Q. How do the returns on junk-bond funds compare with those onhigher-quality bond funds when you look over the long term?
A. That's very interesting... and I bet it surprises a lot of people. Usingthe Lipper Funds Indices, comparing high-yield with US government bondfunds, for the past 10 years the more risky ones have produced an annualtotal return advantage of only 13 basis points, with a return per year of6.69%. Mid-cycle to mid cycle, from the end of 1992, the annual advantagewas just 1.09%. If you start from very scary times, like the end of 1990,you get a bit more than 3 points more per year. Thus, the answer definitelydepends on the window you look through. (and I should add: the indicesreflect the largest funds of each type, so the bad-acting junk funds tendto stay out or drop out, meaning there may be a survivorship bias HELPINGthe junk-funds numbers here!)
Q. So, what comparison would be best to use?
A. I think maybe the 12-year, mid-cycle one is reasonable at this time.And I wonder if it is worth taking on the added volatility and not sleepingas well, to get just 1.1% a year of added return!
Q. How come the results are not more different? I thought the junk bondsand funds pay a much higher yield...
A. They DO pay a higher yield, but ON AVERAGE about 4% to 5% of the bondsdefault each year, so there is a tendency to see erosion of the NAV, yourprincipal, over time -- so the TOTAL return is not much different. And ofcourse if your principal is eroding, that leaves less in assets to earninterest, so your income slides. You could also say they are NOT taxefficient, since you get fully taxable current interest income, and takelong-term capital losses (lower rate)!
Q. It sounds like you are not real keen on these funds...
A. Well, I admit to not being a long-term buy&hold investor. For people whodo that, these funds are NOT a very good idea in my view. They will thrillyou and then scare you, and you may well panic and sell out at the bottom,locking in your losses.
Q. So, never own them?
A. I would own them with discipline and a contrarian's eye, but only atcertain times in the economic cycle. That means buying them when thingsfeel really scary and the yield advantage is big, and selling them when theeconomy is just fine and your returns have been nifty and you are feelingreal comfortable. This is not something I would want to own through anentire economic cycle by any means.
Q. And what about NOW?
A. We are fairly well along in the up-cycle that started in 2001, so Iwould be pretty cautious here. The yield spread now is not even quite atthe average, and the Fed is doing things that will eventually slow theeconomy, and that is not good news for low-quality credits.
Q. Any exceptions?
A. If you can find funds (maybe on LipperLeaders.com) that have along-term return clearly setting them apart from their High Yield peers,and the manager stays at the helm, maybe now. That means those few peoplehave a way of avoiding the periodic disasters, and since the main charteris high current yield, the risk-avoiding approach is rare among managers.So overall I would say it is not the greatest of timing right now to ownthem, on average.
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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