10% Yields in a 5% World - Junk bonds

Steven T. Goldberg

You can easily increase your investment income--at the price of higher risk.

In springtime, an income investor's fancy turns to thoughts of ... beautiful high yields ... winsome double-digit yields ... fond reminiscences of the 1980s, when 30-year U.S. Treasury bonds yielded 15% and just slightly more-risque corporate bonds were even more fetching.

Wake up! Thirty-year Treasuries now hover around 5%, while yields on money-market funds and short-term bank certificates of deposit are just as unattractive. It's easy to get discouraged, but fortunately, there's reason for cheer. Largely due to fears of an economic slowdown, yields of 8% to 10% and higher are once again as abundant as daffodils.

Phoenix Alan is enamored of the yields he earns today. "I'm in it for the income, not the long-term growth, because there's not much inflation right now and, at my age, I'm not planning way, way into the future," says the retired lawyer, who lives near Naples, Fla. "I'd rather have money in the bank than speculative profits on stocks that may vanish tomorrow." Alan gets the income he wants from high-yielding, "junk" bond funds.

The more generous the yield you pocket, Alan knows, the greater the risk you must take. Before you invest in high-yielding securities, "you have to be willing to accept the risks and understand them," he says.

The majority of your income investments belong in safer--and, alas, lower-yielding--investments, such as high-quality municipal-bond funds offered by Vanguard and other fund firms. "We don't recommend that highyield bonds be more than 20% of anyone's bond portfolio," says Scott Brooks, a broker with Edward Jones in Carlsbad, Cal. But for a portion of your income money, stretching for yield can prove profitable.

JUNK BONDS

Because of fears of a global slowdown sparked by the weakness of emerging markets, you can earn 5.5 to six percentage points of yield more on most junk bonds than you can on comparable Treasuries--a gap wider than at any time since the junk-bond collapse of 1989-90. While a slowdown could make it hard for some bond issuers to make their interest payments, Martin Fridson, global high-yield strategist for Merrill Lynch, says that a big rise in defaults by bond issuers is unlikely.

Ben Trosky, manager of Pimco High Yield, recommends the 11.38% Globalstar Telecommunications bonds of 2004. With the cash generated by its bonds, which are rated B by Standard & Poor's, Globalstar plans to set up a low-cost satellite network to provide phone service to developing nations and other areas of the world (in competition with the Iridium network, spearheaded by Motorola). Globalstar's plans were set back last year when a rocket with a dozen of its satellites blew up in Kazakhstan. The bonds are trading at 76 cents on the dollar, giving them a fat 15.6% current yield.

Trosky also likes the 10% Riviera Holdings bonds of 2004, a mortgage issue on a Las Vegas casino. Rated B + because of fears of overbuilding in Las Vegas, the bonds yield 12.6%. Even if the casino goes belly up, Trosky says, "the bonds would be covered just by the land value."

Alan used to buy individual junk bonds when he was working and could follow them every day. "Now, I do it through a fund manager. It's the same thing, but I don't do the work." An even bigger advantage of investing through a junk-bond fund is that if the issuers default on one or two bonds, it won't wipe out your whole portfolio. "For individuals, a fund is the way to diversify," says Kathleen Gaffney, co-manager of Loomis Sayles Bond. Institutional investors, such as mutual funds, also get better prices when buying and selling bonds than do individuals. Brokers sometimes have a hard time finding specific bonds in small enough lots for individual investors.

Fidelity High Income (800-544-8888), which yields 9.6%, is the top-returning junk-bond fund over the past five years and has finished in the top 35% or better measured against its peers every year since 1992. Northeast Investors Trust (800-225-6704), which yields 9.6%, is the top-performing fund over the past 15 years and has finished in the top 10% against its competitors over the past three and five years. About 10% of the fund is in stocks.

LESS-TAXING HIGH YIELDS

Tax-exempt municipal bonds may be the best bargain around. That's because even high-quality munis offer the same pretax yields as Treasuries with comparable maturities. "That's only happened three times this century," says Richard Ciccarone, director of municipal research for Van Kampen funds. "It's a rare opportunity."

Mary-Kay Bourbulas, who runs Strong High Yield Muni fund, recommends 5.95% Connecticut State Development Authority bonds for Connecticut Light & Power of 2028. These currently yield 5.9%. The bonds have a B+, or junk, rating from Standard & Poor's largely because the utility owns part of a nuclear power plant. The bonds aren't guaranteed by the state, and the income may be subject to the alternative minimum tax.

She also likes the 4.75% North Carolina Medical Care bonds for Pitt County Memorial Hospital of 2028. Rated AA- by S&P, the bonds are currently yielding 5.2%. "It's a very high-quality hospital," Bourbulas says. Slightly more risky, single-A-rated, 5% Puerto Rico general-obligation bonds of 2028 yield 5.1%. Puerto Rican bonds have the added bonus of being exempt from state and local income taxes.

(To figure the taxable-equivalent yield on a muni, simply divide it by one minus your tax bracket. So if you're in the 31% tax bracket, divide the 5.1% yield on the Puerto Rican bonds by one minus 0.31. Your taxable-equivalent yield is 7.4%. That's what you'd have to find on a taxable bond to equal the 5.1% muni.)

Note: Most muni bonds are subject to early redemption by their issuers, usually about ten years after they are issued. So 30-year bonds are likely to be redeemed in ten years--unless yields on new muni bonds rise, making it unattractive for issuers to refinance.

As with taxable junk bonds, you're much safer buying low-grade munis in a fund. Strong High Yield Municipal (800-368-1030) yields 5.5% and is in the top 10% in total return among its peers over the past three and five years. The average credit quality of its bonds is BB. T. Rowe Price Tax-Free Income High Yield (800-225-5132) yields 5.2% and has been above average in total return among junk-bond funds every year since 1986. The average credit quality of its bonds is A-, meaning it's not really a junk-bond fund.

CLOSED-END BOND FUNDS

For even higher yields, look to closed-end funds, which are a kind of cross between a mutual fund and a stock. They invest in a portfolio of securities, just as mutual funds do, but they typically issue shares only when they first go public. After that, they trade like stocks--usually at a discount or premium to the underlying net asset value of their holdings. Buy them at a discount and the yield on your investment will be even higher. "You shouldn't invest the rent money," cautions Al Blomquist, editor of The Closed End Fund Reader (201-891-3814), a newsletter. "But if you invest for the long term, there's little danger."

Richard Silverstein and his wife, Nadine, invest in closed-end municipal-bond funds because they know they won't be spending their principal any time soon. "They're a little riskier than open-end funds," Silverstein says. "But we also have an aggressive part of our stock portfolio. If you have a long time horizon, you can go for it," says Silverstein, 51, a dentist in Englewood, N.J.

Closed-end bond funds have some advantages over open-end funds. Because they don't have to redeem shares, they can hold thinly traded issues without fear of investors' withdrawing their money. Many of them boost their yields (and their risk) further by borrowing money at short-term rates to invest in even more bonds.

Mariana Bush, a closed-end-fund analyst with Everen Securities, studies bond funds carefully to make sure they won't have to lower their monthly dividends, which can be disastrous for investors. In December, for instance, John Hancock Patriot Preferred Dividend (ticker symbol PPF, New York Stock Exchange, recent price $12) cut its monthly dividend from 9.65 cents per share to 7.2 cents. Its normally steady stock price fell from $14.75 to $12.13 in a matter of days. Funds typically cut their dividends if a lot of issuers redeem high-yielding bonds prematurely.

Among closed-end muni funds, Bush suggests Nuveen Premium Income Muni (NPI, NYSE, $15; 800-257-8787). It currently yields 5.7% and sells at a 1.1% discount to NAV. She also likes Van Kampen Select Sector Muni (VKL, American Stock Exchange, $13; 800-341-2929). This fund also borrows money to boost its returns. It currently yields 5.6% and sells at a 7% discount to NAV. Bonds in these funds rate, on average, AA.

Among high-yield taxable bond funds, Bush favors High Income Opportunity (HIO, NYSE, $10; 800-544-7835), which yields 10.3% and trades at an 8% discount. Managed by Salomon Smith Barney, this fund doesn't borrow money. Its bonds have an average credit quality of B, and it invests almost 10% of its assets in stocks. For those who want a really big bang for the buck, Bush recommends First Australia Prime Income (FAX, Amex, $6; 800-451-6788), which yields 10.4% and sells at a 16% discount. The fund uses borrowed money to increase its investment in triple-A-rated Australian bonds with an average maturity of about six years. The big risk is that the Australian currency could decline against the U.S. dollar.

DEVELOPING MARKETS

Want some really high yields? Look no further than emerging-markets debt. The yields are awesome. Unfortunately, so are the risks. Sovereign debt of Russia, for instance, maturing in 2001, yields a staggering 64.8%. Of course, Russia is in default on many of its obligations, but not on these--yet. You can also find Nigerian bonds yielding 17.4% and Brazilian bonds yielding 16.7%. But because of the monstrous risks in emerging markets, most experts counsel individual investors to give these bonds a wide berth. "In emerging markets, in particular, you want to buy a mutual fund," says Matt Ryan, an emerging-markets debt analyst at MFS.

Emerging-markets funds should be taken in small measures, too, and are not exactly low risk. For instance, Scudder Emerging Markets Income fund lost 30.3% of its value last year, and the average emerging-markets bond fund plunged 20.4%. But T. Rowe Price Emerging Markets Bond (800-225-5132) offers a 13% yield, the highest among no-load funds, and has returned an annualized 7.1% over the past three years. Says manager Michael Conelius: "Everything in emerging markets is fairly cheap."

FAT OF THE LAND

Because of their corporate structure, which mandates that almost all income flow to shareholders every year, real estate investment trusts (REITs) offer juicy yields. They also offer growth--but REIT stocks can fall, too, as most did last year. Steve Brown, co-manager of Cohen & Steers Equity Income fund, recommends the following REITs:

FelCor Lodging Trust (FCH, NYSE, $23), yielding 9.4%, owns a diversified collection of hotels, including many Holiday Inns and Embassy Suites.

Health Care Property Investors (HCP, NYSE, $27), yielding 10%, is a large owner of nursing homes.

Summit Properties (SMT, NYSE, $17), yielding 9.5%, owns a chain of apartments in the Southeast.

Brown also likes REIT preferreds. Preferred stocks generally pay higher yields than common stocks but offer less potential for price appreciation. (Note: The ticker symbols on preferred and trust-preferred securities vary depending on the data source you use.)

Apartment Investment and Management Preferred G (AIV_pg, NYSE, $23) yields 10.1% and is one of the largest apartment owners in the U.S. The issuer can "call" or redeem this preferred security in 2008 or any time afterward by paying shareholders $25 per share.

Liberty Property Trust Preferred A (LRY_pa, NYSE, $24) yields 9.3% from offices and industrial properties in the eastern U.S. The issue can be called after July 2002 at $25.

QUIPS AND QUIDS

The last two Reits really could have been placed just as easily under this heading. Usually called trust preferreds, these were created by investment houses so that corporations could borrow from individual investors on favorable terms. Still, these securities offer convenience and yield to investors.

Trust preferreds are typically issued in $25 lots. They are called MIPS, QUIPS, QUIDS or TOPrS, primarily depending on which investment house underwrites them. The securities almost always allow the issuing corporation to call or redeem them, usually after five years, if interest rates decline or remain stable. But if interest rates rise, a corporation doesn't have to redeem them for 30 or 40 years. The securities also give the corporations the right to suspend dividend payments for up to five years under certain circumstances.

In return, these securities pay relatively high yields. Michael Stevens, a trust-preferred analyst at Legg Mason, offers this list of his favorite picks:

Bear Stearns Capital Trust II Preferred Y (BSC_py, NYSE, $25), a subsidiary of the Wall Street brokerage firm, yields 7.5% and is rated BBB. It is callable beginning December 2003.

Heco Capital Trust II Preferred T (HE_pt, NYSE, $25) is a subsidiary of Hawaiian Electric. The security yields 7.3% and is also rated BBB, and can be called beginning January 2004 at $25.

Textron Capital Preferred T (TXT_pt, NYSE, $25), yielding 7.8%, is a subsidiary of a conglomerate involved in such businesses as aircraft, industrial products and financial services. The securities are rated BBB+. They can be called beginning February 2001.

PARTNERSHIPS PLUS

Master limited partnerships generally offer higher yields than trust-preferred securities, although investors must wait until March each year to receive a special tax form to use in figuring income tax on MLPs. Much like REITs, MLPs are stocks that must pass almost all their income to their shareholders (officially called unit holders) each year to avoid or minimize corporate taxes. As a result, they offer healthy yields, plus they are easy to buy and sell in the marketplace. Here are the favorites of Ronald Londe, a veteran MLP analyst at A.G. Edwards & Sons brokerage:

Cornerstone Propane Partners LP (CNO, NYSE, $17), yielding 12.7%, is the fifth-largest propane distributor in the nation.

Crown Pacific Partners LP (CRO, NYSE, $21), with a 10.5% yield, owns forest products in the Northwest.

Enterprise Products Partners LP (EPD, NYSE, $18), yielding 10%, refines natural-gas liquids into propane, butane and other products.

Because they have such high yields, these MLPs have low growth potential, and their prices tend to drop when commodity prices fall.

UTILITARIAN YIELDS

As competition heats up among utilities, yields are declining a bit because companies want to retain earnings to fight off (or purchase) competitors. Still, some utilities pay generous yields. Mark Luftig, an analyst with W.H. Reaves & Co., offers these selections:

Ameren Corp. (AEE, NYSE, $38), yielding 6.8%, is located in the Midwest. Luftig expects earnings to grow.

Hawaiian Electric Industries (HE, NYSE, $36) is one of the best-insulated utilities against competition because of its location. It yields 6.9%.

Western Resources (WR, NYSE, $29) provides power in Kansas and Oklahoma and also owns a large home-security business. It yields 7.4%.

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