High-yield bonds: Appetite for risk

Like most investments with higher credit risk, the high-yield bond market took a huge hit in 2008 as investors fled to quality. But with the sector recently seeing its deepest discount ever - and even rallying a bit - some say it's time to test the waters again.

"The values are just extraordinary," says Martin Fridson, CEO of Fridson Investment Advisors and a high-yield bond specialist. "I think it's an opportunity you're not going to see very often in your lifetime."

Fridson says the spread between high-yield bonds and treasuries over the last few months has been far beyond anything seen before. The option adjusted spread, which measures the difference, is about 17.6 points, according to Merrill Lynch data. A year ago, the spread was 8.2 points.

Lower valuations mean more upside, Fridson says, but they're also the reason for investors' hesitations. Default rates will likely run higher than during past recessions, he notes, partly because the quality of the sector has deteriorated since the last low cycle.

Lawrence Jones, associate director of fund analysis at Morningstar, said some experts he's spoken with expect default rates, which have run between 2% and 3% the last few years, to reach between 10% and 15%.

"I see the opportunity," Jones says, "but almost everyone who's being straight with you will say there's a lot of risk."
You may know them as "junk"

High-yield bonds, or "junk" bonds, are defined by the industry as a bond with below a Standard and Poor's BBB- rating. They have a higher risk of default (failure to make a scheduled interest or principal payment), and are subject to greater price swings than more highly rated bonds. But on the upside they also have a higher rate of interest.

Jones suggests making high-yield bonds a small part of your portfolio through bond funds run by experienced managers and research teams investing in better-quality high-yield securities. A fund provides the advantage of a manager's expertise and also the diversification that's needed to limit the risk of default in any single investment. And high-yield bonds can be highly illiquid, i.e., hard to unload if they're thinly traded, but a fund gives you the security of getting in and out when you want.

A small and relatively new entry, which has benefited through conservative investing, is the Intrepid Income Fund. It isn't limited to high-yield - it also holds investment grade and convertible bonds. Morningstar doesn't rate the fund, but it calculates its year-to-date returns at 5.65%, beating out the high-yield sector average of 3.38%. One-year returns fell 7.05% but were well above the category's drop of 21.14%.

Intrepid Income has a greater percentage of its assets in higher-quality debt than is typical for the high-yield bond category, says Jones. About 20% of its assets are in cash, according to Morningstar, which he believes tempered the fund's 2008 loss because the cash held up as the high-yield bond market collapsed. But the fund is not quite two years old, Jones notes. "It's not clear to me whether they're good fund managers or lucky managers," he says.
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Of course fund managers Jason Lazarus and Ben Franklin think there's more than luck involved. They say they can spend more than 60 hours researching one name for their fund, which has $37.5 million in assets under management.

"We like to pride ourselves on not being economists," says Franklin. "We're bottom-up fundamental research analysts."

The fund has only about 30 names in its portfolio and holds concentrated positions in each one. The concentrated positions do, however, reduce diversification. "The reason that we do that is because we can be very confident in the few names that we do own," Lazarus says.

In selecting investments, they consider credit metrics, such as leverage ratio. They look for companies that can cover their interest expenses by a healthy margin to make sure they're going to get repaid in any climate. And while some funds anticipate defaults in their portfolios this year, Lazarus and Franklin expect to avoid these landmines.

The bulk of their work is qualitative, as they try to determine the quality of management, direction of the company, and how cash flows are going to trend over the course of a business cycle. They look for businesses they think will do well in any environment, and they like bonds with short durations (less than five years). Longer-duration bond prices generally fluctuate more with interest rate changes, they say. It also allows them to be more certain in their short-term outlook.

Because Intrepid Income is a small fund, Lazarus and Franklin can invest in issues with about only $150 million in bonds outstanding, while a larger fund wouldn't be able to establish a meaningful position in an issue that small. Fridson says it's hard for large funds to avoid looking like an index. Smaller funds may be able to underweight the less attractive industries, which is harder to do as a fund gets larger.
What catches Intrepid's eye

Here's how their thinking plays out in some of Intrepid Income's representative holdings: (Note that individual investors shouldn't invest in any single junk bond because the risk is too great.)

Silgan Holdings: manufactures metal and plastic containers for companies like Campbell's.

"We like seeing a company that has recurring revenues that we can trust even in a down market," says Franklin. "Many of these companies like Silgan, their operating margins aren't huge, but they're sufficient and we think they'll be able to survive in any situation."

Phillips Van Heusen: one of the world's largest apparel companies.

"We like them because they actually can almost cover their entire amount of debt with cash alone," Lazarus says. "And while we believe they probably won't do that, they may do a strategic acquisition."

Prestige Brand Holdings: makes and sells household names like Comet, Clear Eyes, and Chloraseptic.

"They don't manufacture anything themselves," says Franklin. "They outsource everything. They have almost zero capital requirements to put back into the business. That allows them to use all their free cash flow for acquisitions or paying down debt."

Rent-A-Center: runs a rent-to-own business.

"That bond actually has a one-year to maturity, which is definitely a feature we like," says Lazarus. "It's capitalizing on that sort of customer that wants to go out and buy a TV or needs to buy say a new washing machine or refrigerator but can't get financing from say, Home Depot."