High Yield (Junk) Bond Funds: Past, Present and Future

High yield (junk) bonds are corporate bonds that are rated below investment grades which are reserved for the highest quality borrowers. Investment grade bonds are rated AAA, AA & A. Because those standards are so stringent, BBB, the next grade, is considered marginal investment grade. Bond ratings of BB, B & C are below investment grade (called junk bonds) because they carry higher risk. Buying individual bonds was always a little inconvenient plus very few corporate bonds (including those below investment grade) were readily available for trading by individual investors.
High yield (or junk) bond funds have been around for a good 20 years. They enable investors to buy shares in a portfolio of bonds rated below investment grade to obtain their high yields. In the past, net interest, after expenses, typically yielded about 9% (roughly 400 basis points above the Treasury bond rate) to investors. In the very best of days, junk bond fund yields were below 9% while down markets might force the rates upward towards 10%.
The fortunes of junk bonds have been running in roughly 10 year cycles. The two very ugly periods were around 1990 and then around 2000. 2009 will be their third trial period. These last two periods saw a rise in default rates causing lower dividends paid by junk bond funds. But they did muddle through and persevered.
Barclays (formerly Lehman) High Yield Bond Fund (JNK) is a junk bond market index but only has a one year history. It was pretty much flat in the first 6 months of 2008, remaining near 45. In the next two months it slipped to 43 in the weak stock market. Then came September when it ran into a brick wall, like the rest of the market. It dropped to 27 by the middle of December which raised the yield to over 16% or 1400 basis points above the Treasury bond rate. Since then it's rebounded as tax loss selling on related stocks ended and bargain hunters bought greatly oversold securities.
Turmoil in the financial markets starting with Q4 of 2008, brought new metrics for interest rates on junk bonds. In just a few months, yields on junk bond funds skyrocketed to 20+% or 2000+ basis points above the depressed yield on the long term Treasury bond. In the last couple of weeks, bargain hunters started buying junk bond funds to lock up extraordinarily high yields or maybe for quick profits on a short term rebound bounce.
In recent years, funds expanded their range of securities by adding emerging market bonds to their portfolios. These are bonds in foreign companies or countries, typically in eastern Europe, Latin America or Asia representing diversification by geography. The track record for these bonds is limited. But this year, emerging market bonds didn't decline as badly as US junk bonds did. Diversification by geography can be rated as a plus or minus. I view this form of diversification as a plus since a portfolio is not solely tied to the US economy.
As usual, the future is uncertain and high risk bonds face hazardous times given the turmoil in the financial markets. However yields on these securities remain at historically high yields and record premiums over the Treasury bond yield. The future for junk bond funds is not as bleak as some might assume. Let's take a look at a mythical fund, Risk Fund, in today's markets.
Risk Fund
Market price....5.00Dividend.........1.20Yield.................24%
Assuming the dividend is reduced to 80¢, when more traditional markets return a future valuation of the dividend might be around 10%. These assumptions would produce a future valuation:
Market price....8.00Dividend.........0.80Yield.................10%
Under this scenario, the higher dividend would be paid until cuts are made (possibly in 2009). Risk Stock fund this year might pay $1.00 in dividends followed by $.80 next year. The dividends and capital gains would give very attractive rates of return. Even the lowered dividend would provide a nice yield going forward.
I just received an interim report from a high yield fund. After 5½ years, the current net asset value is more than the starting net asset value plus accumulated dividends. The starting point was a fairly "good" time while present values are exceedingly low.
Exceptionally high yields on junk bonds are needed to compensate for the unusually high risk levels associated with these bonds. But where there is chaos, there is opportunity. A small portion of a portfolio could be invested in junk bond funds to earn exceptional yields which is gathering interest of the very brave investors.

Avi Morris ( Mad Money Reader )