There's Value In High-Yield Bonds

3/16/2009


The average high-yield bond fund has tumbled 24% over the past year — the worst showing among classes of fixed-income funds. So where is the appeal in funds that hold securities commonly referred to as “junk?” Aggressive investors now have an opportunity to exploit near-record yield spreads.

Over the past 25 years, junk bonds have typically offered yields four to five percentage points above Treasurys. But the spread hit 20% late last year and remains near historic levels. The Merrill Lynch U.S. High Yield Master Constrained Index yields 20.7%, versus 3.0% for the 10-year Treasury bond. Based on the Merrill Lynch High Yield 100 Index, which holds the 100 largest junk bonds, the spread is roughly 10%.

Of course there is a catch — default rates on corporate bonds have accelerated, sending bond prices sharply lower and yields skyrocketing. According to Moody’s, a total of 101 corporate bond issuers worldwide defaulted in 2008, up from just 18 in 2007.

U.S. companies accounted for nearly three-quarters of defaulters, with the bankruptcy of Lehman Brothers the largest in history.

2009 could be even worse, as Moody’s predicts that the default rate for bonds below investment grade will approach 15% — levels reported during the Great Depression. According to Moody’s, the number of corporate defaults will triple to about 300 this year.

Even with a tenuous backdrop, the high yields available on junk bonds appear to overcompensate investors for the risk of default. A back-of-the-napkin calculation shows that recent yield spreads exceed projected losses.

Since 1982, the recovery rate (the percentage of a debt’s par value that creditors collected after a default) has averaged 41.4%, putting the loss rate at 58.6%. Multiplying Moody’s projected default rate of 15% times the loss rate of 58.6% equals 8.8% — the “break-even” spread needed to offset projected losses. At 17%, the current spread between the yield of the High Yield Master Constrained Index and the Treasury bond is nearly double the 8.8% expected loss.

Recommendations
High-yield funds are aggressive investments. Still, lofty yields and the potential for a rally justify adding the funds to a diversified portfolio. Subscribers should consider Wells Fargo Advantage High Income ($6; STHYX) our top pick. The fund is taking the place of USAA High-Yield Opportunities ($5; USHYX) in our recommended Conservative and Growth Portfolios. Wells Fargo Advantage High Income, yielding 10.3%, tumbled 18.3% last year but is up 0.9% in 2009.

FORECASTS FUND RECOMMENDATIONS
Through Mar. 10, our recommended Growth Portfolio declined 17.0% this year, versus a loss of 19.8% for its benchmark portfolio and a loss of 19.8% for the S&P 500 Index. The conservative Portfolio fell 13.1%, versus a loss of 15.3% for its benchmark.
— Year-to-Date —
—— % of Portfolio ——
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Baron Asset ($29; BARAX)
(19.2)
E
6
7
Dreyfus Small Cap Stock Index
($10; DISSX)
(27.4)
E
6
8
Fidelity Export & Multinational
($12; FEXPX)
(13.9)
D
6
8
Fidelity Leveraged Co. Stock
($11; FLVCX)
(21.5)
E
0
0
Heartland Select Value
($14; HRSVX)
(20.4)
B
5
9
Heartland Value Plus
($15; HRVIX)
(20.6)
A
7
8
Northern Small Cap Value
($7; NOSGX)
(30.0)
E
0
0
T. Rowe Price Int’l Discovery
($10; PRIDX)
(16.7)
B
5
7
T. Rowe Price New Horizons
($15; PRNHX)
(15.9)
A
0
0
Vanguard 500 Index
($67; VFINX)
(19.8)
D
7
7
Vanguard Dividend Growth
($9; VDIGX)
(15.9)
A
8
10
Vanguard Emerging Mkts. Stock
Indx. ($13; VEIEX)
(10.1)
B
0
5
Vanguard GNMA ($11; VFIIX)
0.9
B
6
0
Vanguard Inter.-Term Tax Exempt
($13; VWITX)
2.4
D
0
0
Vanguard International Value
($18; VTRIX)
(21.2)
B
8
9
Vanguard Short-Term Invest.-Grade
($10; VFSTX)
0.7
B
0
0
Vanguard Total Bond Mkt. Index
($10; VBMFX)
(1.3)
C
20
0
Vanguard Wellesley Income
($16; VWINX)
(11.0)
E
0
7
Vanguard Wellington ($21; VWELX)
(13.3)
D
9
10
Wells Fargo Advantage
High Income ($6; STHYX)
0.9
B
7
5
* Rankings through Mar. 10 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. c Closed to new investors.

Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com