From the September 2007 issue of Investment Advisor • Subscribe!

Diamonds Among The Junk

High-yield bonds--those fixed income securities rated below investment grade--have some advantages over more vanilla-type bond products. High yield or "junk" bonds offer higher interest rates than Treasuries or quality corporates; they provide higher yields; and since they sport low correlation with other fixed income securities and stocks, they provide an important diversification benefit.

High-yield securities also come with a higher risk of default, more volatility, and their issuers are more vulnerable to economic downturns. Still, high yield bonds have been very popular, particularly among private equity firms who have used this cheap form of debt to finance speculative M&A deals and leveraged buyouts.

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But with the recent dramatic surge in interest rates among corporate junk bonds, trouble may be brewing. One of the world's leading bond experts, PIMCO's Bill Gross, believes the ongoing woes among subprime mortgage-backed securities is spreading into the high-yield sector--warning that credit markets are confronting a "sudden liquidity crisis." Gross believes this will have an adverse impact on private equity deals and leveraged buyouts, as many debt offerings are already being postponed or even cancelled.

One of the best recent performers in this sector, the $4.14-billion Pioneer High Yield Fund, focuses on total return rather than current income, allocating assets to both high-yield and equity-related securities. As of June 30, 2007, portfolio manager Andrew Feltus had 51.6% of the fund's assets invested in high-yield corporate bonds, and 15.6% in convertible bonds. B-rated securities made up half (50.3%) of the fund's assets, followed by BB (31.0%).

Perhaps the best performing high-yield portfolio of recent years, the $920-million John Hancock High-Yield Fund, has an emphasis on high current income and typically invests at least 80% of its assets in below investment-grade securities.

As of June 30, 2007, manager Arthur Calavritinos had 28.1% of assets invested in securities rated CCC and 28.4% in bonds rated B.

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