There have been times when scarcely anyone has had a good word to say about high-yield bonds. They've suffered badly in recessions or when interest rates rose fast--or simply when investors lost confidence. They're the bonds of companies whose prospects of meeting their debt obligations are rated lower than those of the leading companies. Bad news about them, their industry or the economy can throw those prospects into question.
In recent years, however, their top performance has confounded critics. For example, Northeast Investors Trust, the bond fund listed by Morningstar as the one with the best performance in the five years ending June 30, 1997, had a total return in that time of 99 percent. "High-yield bonds are a superior asset class," says Ernest Monrad, who manages the fund with his son Bruce.
In those five years, Northeast Investors has benefitted from high economic growth and low inflation, which help companies' earnings grow and keep interest rates low. That, in turn, increases the cash flow needed to pay their bondholders.
The Monrads favor companies whose public perception underestimates strength. Ernest cites some gaming stocks, where the customer, not the casino, runs most of the risks (the casino gets a percentage of every play). The Monrads like to meet the management of a company whose bonds they're considering to find out if it has established a way of ensuring investors who buy its bonds get paid. It's more than an academic question--the fund managers have their own money invested in the fund.
The fund is flexible. At times it's had half its portfolio in electricity bonds, at other times, none. It normally doesn't own cyclicals but will do so when the business cycle is turning up.The fund has also built a record of caution. It appears on Morningstar's list of the 10 least risky funds of its type, and it has had only one down year in the past 15. It typically holds the bonds of nearly 100 different companies in various industries.
The feature of most interest to investors, of course, is that the bonds pay high dividends. Recently, Northeast had a dividend yield of more than 8 percent. That's not far short of the near-10 percent annual rate of return that large U.S. company stocks have traditionally produced for shareholders over the long haul. Funds of this type have also been able to add significant capital gains in recent years, although clearly, with interest rates as low as they are, they no longer have the potential those years of falling rates gave them. Northeast, however, does have another feature Morningstar draws attention to: low expenses.
One word of caution: Don't invest large amounts of money in high-yield bonds unless you have a long-term horizon. But that's true of stocks, too. One plus to high-yield bonds' ups and downs is that they don't follow other markets slavishly. For people with a heavy commitment to traditional bonds or stocks, this could be a good way to diversify.
Reg Green edits Mutual Fund News Service, a mutual fund newsletter. The above opinions are those of the author and not of Entrepreneur. Past performance is no guarantee of future returns.