Elizabeth Rodgers of Westchester County, N.Y., is the rare widow whose friends don't offer financial advice, so she winds up listening to fast-talking brokers. In 1986 she invested $5,000 in the Prudential-Bache High Yield Fund, thinking she could enjoy the fund's tempting 12.8 percent yield without risking any significant amount of principal. But in last fall's junk debacle, when junk bond prices dropped as much as 10 percent in a six-week air pocket that ended Oct. 20, she sold for a loss of $733.
Ms. Rodgers' experience isn't unique. Brokers and mutual fund companies have aggressively marketed junk bond funds to millions of small investors on the promise of high yields and little risk. The promise has not been kept, however. Not only have the funds been volatile, but they have also provided poor returns. Over the past three years, high-yield funds have earned an annual average total return of only 4.6 percent, compared with 7.4 percent for high-quality corporate bond funds.
Moreover, the performance of junk funds is getting worse. From last January through Nov. 10, more than 70 of 88 widely held junk funds suffered share-price declines of more than 5 percent. Even with their annual yields of 12 percent to 16 percent, the funds lost an average of 1.3 percent over the same period, while high-quality bond funds provided a total return of 11.4 percent.
Furthermore, some experts warn that the real carnage in the $200 billion junk market is still to come. "We've just begun to see the blood on the floor," says Steven Leuthold, an institutional investment adviser in Minneapolis.
To alert readers to the funds' hidden dangers, Money magazine analyzed 11 representative funds, bond by bond, including some of the largest funds as well as smaller funds reputed to have lower-quality portfolios. Our findings, even about the big funds, were scary:
While the funds have declined in share price over the past three years, we found that many of them have not yet fully recognized their true losses. Bonds are carried on the books at values as much as 35 percent above what they would bring if they were sold. Therefore, anyone buying shares now is paying an inflated price.
Some funds are loaded with illiquid bonds -- issues of less than $200 million that would be hard to sell quickly at a fair price. Many of these issues were underwritten by Drexel Burnham Lambert, whose former chief junk trader Michael Milken has pleaded innocent to 98 counts of stock manipulation and securities fraud. The firm itself has pleaded guilty to six felony counts of mail and securities fraud. Drexel remains an active underwriter and accounts for 45 percent of all junk bond trading. But some analysts say that if legal and financial troubles forced Drexel to curtail its marketmaking -- especially in issues it has underwritten -- trading in many small issues could dry up.
Some funds also contain a large number of bonds with far-above-average default risk. The argument for junk bonds -- that yields of 12 percent to 16 percent will more than compensate for an occasional loss of principal -- assumes that a typical portfolio's defaults can be held to 2 percent or 3 percent a year. But junk watchers now say that the overall default rate could top 10 percent in a recession. Moreover, the most vulnerable classes of bonds make up as much as 30 percent of some of the portfolios we studied.
These discoveries suggest that junk bond fund investors are likely to face declining income payouts and further principal losses of 10 percent to 20 percent over the next two to three years. And if small investors start making large withdrawals from junk funds, as they did last October when they pulled out $1 billion in a single month, events could turn ugly fast.
Says Jay H. Lustig, manager of the high-yield division of Drake Capital Securities Corp. of Los Angeles: "We've learned from experience that when people head for the exits in this market, nobody wants to buy."
The worst-case scenario: To raise needed cash, funds dump bonds at distress prices, pounding down junk generally. And since only higher-quality junk would readily find buyers, funds would have to sell their better bonds first, thereby melting down their portfolios to the lowest-grade issues.
Regrettably, after last October's rapid outflow, many small investors slowed their withdrawals and even began tiptoeing back into junk funds. The lure: the kind of double-digit yields that investors became accustomed to on safe money-market funds in the early 1980s. And a broker who steers a client with $50,000 into a high-yield fund can make five times the commission he or she would get from selling blue-chip stocks.
If you don't own any junk bond funds, stay clear of them. If you're already in a fund, your decision is tougher. Perhaps the junk bond market will improve, enabling you to recoup some of your losses. Often, it's better to take your loss and switch to a more promising investment, rather than wait to get even.
Here's a close look at the results of Money magazine's junk fund analysis:
Price change and total return
Money magazine compared the pricfrom junk-bond funds
ing of about 80 percent of the bonds in each portfolio with actual market values and discovered many issues carried at anywhere from 10 percent to 35 percent above their real values.
Fund managers have a direct financial incentive to overstate portfolio values; their fees are figured as a percentage of assets under management. They can get away with unrealistic pricing because of the way portfolios are valued. Not all junk bonds trade every day, so prices frequently have to be estimated. There are three common methods:
The first, based on computer models, often doesn't track real market values very well. For instance, a typical computer program would set a price of $790 on a $1,000 CrossLand Savings 11.25 percent maturing in 1988, based on the bond's quality rating and the current level of interest rates. The actual market price for the CrossLand bond, though, is $550. The second method, using New York Stock Exchange prices for the few junk bonds that trade there, can be manipulated easily. The third method consists of so-called hand pricing -- asking a friendly broker for an appraisal. That appraisal value, however, will not necessarily be a price the broker would actually be willing to pay.
Percentage of small issues
Because few analysts follow issues of $200 million or less, the difference between a seller's asking price and a buyer's bid price will probably be 5 percent to 10 percent of the bond's face value. If a fund has to sell such bonds quickly, it will have to accept a markdown at least that large.
Percentage of Drexel issues
Many Drexel bonds were issued as part of rickety corporate restructurings and therefore present above-average risks. Without Drexel's support, analysts say a lot of these bonds could plunge in value.
Last summer, for instance, Drexel decided to liquidate $245 million worth of its High Income Trusts -- selling the bonds that these unit trusts held and distributing the proceeds to unit holders. Other firms lowered their bids as soon as they learned Drexel's trusts had to sell.
Percentage of holdings over 5%
When a fund owns a big chunk of a bond issue, the odds are that it would not be able to sell out its position without adversely affecting the bond's price. The funds we surveyed have hefty holdings of both large and small issues: Dean Witter High Yield owns 38 percent of McCrory 15.75 percent bonds, maturing in 1991. Franklin AGE has 20 percent of Pacific Lumber 12.5 percent of 1999. Oppenheimer High Yield has 33 percent of Scovill 16 percent of 1999.
Average issue age
A recent Harvard Business School study concluded that the older a bond issue, the greater its chances of a default. Most of the issues now outstanding were brought out in the past five years to finance takeovers and buy-outs, and as these bonds age, their default risk increases. Oppenheimer High Yield Fund ranks worst in our table, with an average bond age of six years.
Holdings of zeros and piks
Zero-coupon and pay-in-kind bonds are especially lethal time bombs. Most junk bonds pay current interest -- that is, regular payments in cash. Zeros and PIKs don't throw off any cash at all; they accrue interest or pay by giving you more bonds. The result: While you may lose your principal when a regular junk bond defaults, you still have all the interest you received up to the default date. But if a zero or a PIK defaults -- even one month before it comes due -- you end up with nothing at all.
The great nightmare for junk bond fund managers is a recession that triggers the portfolio meltdown described earlier. Unfortunately, as the junk bond market has grown since 1986, poorer-quality issues have multiplied, making the market more vulnerable to recession, explains Barrie Wigmore, a retired general partner at Goldman Sachs.
Paradoxically, a strong economy could mean trouble for junk funds, too. Fund payouts could be eroded if the issuing companies find themselves in strong enough financial shape to call -- or redeem -- junk issues early, perhaps in part, by selling new debt at lower yields. "In fact," says Paul Asquith, finance professor at Massachusetts Institute of Technology, "of all the bonds issued in the period 1977 through 1982, as of December 1988 one-third had been called."
As if these dangers weren't enough, some closed-end funds inflate their risk by borrowing to buy additional high-yield bonds. The results can be devastating. In December 1988, Morton Miller, a 68-year-old gynecologist in North Miami Beach, invested $40,000 in Prospect Street, a leveraged, closed-end junk fund then yielding 14.4 percent, at the original issue price of $10 a share. The fund slid to less than $7 a share by last September, leaving Miller with a $12,000 loss.
Managers of some of the better-run funds pooh-pooh any talk of a calamity. Edward D'Alelio of Putnam High Yield Trust says he believes turmoil just provides opportunities for funds that have the cash to buy solid issues at low prices. In fact, so-called vulture funds are being created to capitalize on any distress sales.
But before you put money into a junk bond fund, ask yourself whose bonds the vultures are waiting to snap up for cents on the dollar. The answer: They're circling slowly, waiting to buy from you.