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Junk Time?

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Now’s a good time for advisors to put some junk into their clients’ portfolios, according to Margie Patel, manager of the Pioneer High Yield fund (TAHYX), because high-yield junk bonds are poised to outperform equities.

Patel, who joined Pioneer in 1999 after the Boston-based investment company acquired the high-yield fund that she’d been managing for Third Avenue Funds, is a value investor who searches for industries with good fundamentals, high barriers to entry, and ones that are growing–preferably faster than the economy. She then looks for companies in those industries that are leaders in their product niches.

Her fund’s philosophy differs from other high-yield funds in its industry approach because she doesn’t “benchmark any index or try to use the same industry weightings as an index of the high yield market.” Most other high-yield funds, she says, “are either de facto or closet indexers as an investment philosophy and as a way to attempt to reduce risk.”

In scanning for value, Patel says she also looks for opportunities in out-of-favor industries and companies, and will latch onto one if she sees that there are near-term catalysts to turn around company operations and to improve investor sentiment, such as changing supply/demand fundamentals, or new management.

Her approach seems to be paying off. In 1999 and 2000, the Pioneer High Yield Fund was the best performing high-yield fund by return, according to Morningstar, returning 27.1% in 1999 and 12.8% in 2000. And she hasn’t faltered lately, either. According to Principia, the fund is still in the top percentile of all high-yield bond funds for both the three-year period ending July 31 (a 14.9% return), and for the past 12 months (11.2%). The fund does have a 4.5% front-end load.

Patel has steered the fund to such stellar results by avoiding the telecommunications, retail, and entertainment sectors. The fund’s top five holdings are technology, energy, consumer, utilities, and broadcast/communication services.

She got out of telecom in 1999 and has stayed out because many telecom companies are defaulting. “A lot of these companies are hitting the wall because there’s a question of whether they can service their debt before they run out of money,” she says. “The big increase in defaults is real, but it will largely be confined to the telecom sector.” She says that telecommunication service has become commoditized. “[These companies] may not all fail, but I think there will be an increasing number of them that will fail.”

Patel recommends advisors consider allocating as much as 20% of risk-oriented clients’ fixed-income investments to high yield because interest rates are very low by historical standards and a large number of investors are income-oriented. “At a time of low interest rates, people are always looking for ways to supplement their interest income,” she says. “So for an investor who can handle the risk of buying into speculative grade bonds, this is one way to use a limited amount of their fixed-income assets to invest.”

Poor equity market performance is another reason to veer toward high yield. “If you’re in a market where returns are going to be much closer to the historical in terms of 9% to 12%, suddenly income becomes much more attractive as a total rate of return,” Patel says.

And the Federal Reserve’s 25-basis-point interest rate cut to 3.5% from 3.75% on August 21 is another plus for high-yield funds. The Fed rate cut is “positive for high-yield credit because virtually every company has some sort of short-term financing. So anytime the rates go down, the cost of doing business is lower,” she says.

Patel says the Fed rate cut will also help stimulate the economy, and she expects that within six to 12 months, depending on which sector a company is in, businesses will stabilize and show better results. If the economy expands, “then typically most companies will have better operating results, higher revenue, and better profits,” Patel says. “So if you feel a company is going to do better, you’ll be more willing to buy their bonds and take a risk as opposed to when it’s in a recession, and you don’t know how poorly they will do.”