From the November 2008 issue of Wealth Manager Web • Subscribe!

November 1, 2008

Fund of the Month

Desperate to find safety, investors have been fleeing to Treasuries and dumping high-yield corporate bonds, which are rated below-investment grade. During the year ended in August, the average high-yield fund lost 2.4%, lagging intermediate government funds by more than six percentage points, according to Morningstar.

But now the selling of junk may be overdone. Lately junk yields have been spiking--topping 13% for many bonds. That is about 10 percentage points higher than comparable Treasuries. In the past, when spreads over Treasuries became so wide, junk bonds soon recovered. The last time spreads hit double-digit levels was back in 2002. The following year, the funds rebounded and returned 24.4%.

Bears worry about rising bond defaults. Over long periods, high-yield bonds have recorded average annual default rates of about 4%. Occasionally during economic downturns, the annual rate has spiked to 10%. If that happens in the next year, junk funds will likely slip into the red. But if the rate stays below 7%, high-yield funds could prove to be winning investments. So far the default rate is around 2%. With Washington striving to prop up the credit markets, defaults could easily stay in single digits.

Whether or not junk funds soar this year, they can still make intriguing holdings. Besides paying rich yields, the funds can help to diversify fixed-income portfolios. Sometimes junk funds stay in the black when high-grade issues are suffering losses. This can occur during periods when the economy is expanding and interest rates are rising. Bond prices typically fall when rates are rising. But during periods when the economy is healthy, default risk declines. That can help boost prices of junk bonds.

Which high-yield fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by FI360, a consulting firm in Sewickley, Pa. FI360's due diligence process seeks funds that are at least three years old and have a minimum of $75 million in assets. Three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must fall below the top quartile, and at least 80% of the fund's holdings must be consistent with the category.

The screens reduced the field from 472 contenders to 75. Top finishers included Julius Baer Global High Income, MFS High Yield Opportunities and Pioneer Global High Yield. But we awarded the title to Principal High Yield, which had the highest five-year returns among the finalists as well as a high alpha.

Portfolio manager Gary Pokrzywinski compiled this strong record by focusing on bonds that stand to benefit from sustained industry-wide trends. When airlines faltered following the terrorist attacks of September 11, he began emphasizing the sector. "After some airlines went out of business, that reduced the supply of seats and improved the long-term outlook for the surviving companies," he says.

As the air traffic revived, prices of airline bonds recovered, and Principal recorded nice gains. Pokrzywinski sold most of his airline positions in 2006, worrying that oversupplies would plague the industry.

Searching for bargains, he sometimes takes contrarian stances. After Enron went bankrupt in 2001, investors dumped bonds of merchant power producers. That attracted his interest. "Once things collapsed, the industry stopped adding new plants, but demand for power continued growing by more than 1% a year," he says. "Now it will probably be a few more years before the supply of power catches up with demand."

Convinced that the aging population will demand more health services for years to come, Pokrzywinski has been emphasizing hospitals and pharmaceutical companies. Longtime favorites include bonds of Tenet Healthcare, which operates general hospitals, clinical laboratories and medical office buildings; and HealthSouth, which runs rehabilitation hospitals. Some hospital securities have declined recently as investors worry that a new president might encourage more regulation--and lower profits--for the health sector. But Pokrzywinski is convinced that the sector will remain resilient. "The government will allow these companies to earn reasonable returns," he says. "Health companies will continue enjoying stable revenues."

Pokrzywinski sometimes buys stocks or convertibles when they seem to offer the most attractive vehicles for investing in companies. Recently he bought below-investment-grade convertibles of CV Therapeutics, a biotech company that focuses on the treatment of cardiovascular diseases. Prices of the convertibles dropped when Wall Street was disappointed with the sales of a product used to treat angina. But Pokrzywinski argues that the company has a sound balance sheet, and new uses for the drug could help to boost sales.

Like many high-yield funds, Principal typically emphasizes bonds rated 'B,' two steps below 'BBB,' the lowest investment-grade rating. But in recent months, the fund had 21% of its assets in investment-grade securities. That helped to prop up returns during the market downturns of the summer and early fall.

To be sure, Principal has no long-term plans to stay away from bonds rated below investment grade. Pokrzywinski says he has his eye on junk financial securities. Now that many have been pounded for months, they are starting to reach cheap levels, he says. By snapping up financial bonds at bargain prices, the fund can continue delivering the strong returns that shareholders have come to expect.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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