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Gail MarksJarvis: Worried about junk bonds? Check your fund ratings

McClatchy-Tribune Information Services

December 21, 2015

Now you see why high-yield bonds are called junk.

They can be sloppy and unreliable ó sometimes the stinkiest garbage from the junkyard of the bond market. And they can stink up your investments, too. They have lost about 8 percent this year.

High-yield bonds are included in the type of funds you might own. They are sold to investors by weak companies that need cash. These companies canít get loans from more cautious lenders who are afraid of not getting paid back. So the weaklings turn to investors willing to take chances. Higher interest rates, or high yields, are the bait offered to investors to take chances they otherwise wouldnít.

During the past few years, cautious people, such as retirees, let down their guard against junk, because they were getting paid almost no interest on safe bonds or CDs. They bought high-yield bond funds and high-yield exchange traded funds such as the iShares iBoxx High Yield and SPDR Barclays High Yield. Some plain vanilla bond funds are also stuffed with junk. Regular bond fund managers added junk to their funds so youíd be happier with larger returns than you were getting on safer bonds.

Now thereís been a scare in the market. Many high-yield bonds have been issued by companies in the energy business, and they are in distress as oil prices plunge. Savvy investors have wondered if many of those companies will go bankrupt and infect the entire high-yield bond market. And as scared investors have tried to sell these bonds, theyíve had trouble finding buyers. As a result, the sellers have had to drop the price so they could get buyers. Thatís set off a downward spiral of losses.

Fear intensified this month when a particularly risky high-yield bond fund, the Third Avenue Focused Credit Fund, collapsed and wouldnít let investors pull their money out. The action, the fund managers said, was to try to stabilize the fund so investors wouldnít end up losing more.

But blocking people from leaving was unnerving. People invest in mutual funds so they can get their money back whenever they want. Analysts started to wonder aloud in interviews whether Third Avenue Focused Credit Fund was the canary in the coal mine for junk bond risks. Some made comparisons to Bear Stearns and Lehman Brothers in the financial crisis in 2008.

"All of us are skittish because so many of us missed the subprime blowup," said Craig Elders, fixed income analyst for Robert W. Baird. Yet, the markets have calmed in recent days.

"If no large fund or hedge fund blows up during the next couple of weeks, it should be OK," he said.

Now, some analysts are talking about deals in the market since fear and selling lately have caused prices to fall sharply. In August, yields shot up because of worries about a slowing global economy and risks of bankruptcy among energy companies. Then, high-yield bonds on average were yielding about 7.5 percent, but now are about 8.7 percent.

"Thatís a huge swing," Elders said. It doesnít mean investors arenít taking risks, but when yields are that high individuals are getting compensated for taking the risks. The risk will be worth it if there isnít a panic set off by more collapsing funds or by bankrupt energy companies unable to pay back junk bond investors.

Analysts such as Sarah Bush of Morningstar are pointing out that most high-yield mutual funds have far less risky portfolios than Third Avenue Focused. The fund, she said, invested heavily in extremely distressed names.

Investors worried about risks, she said, can check the contents of their funds. If they see bonds rated CCC or less, that shows their fund is taking on a lot of risk. In the Bank of America Merrill US High Yield Master Index, 13 percent of bonds are CCC or worse. Exceeding that percentage is very risky. Staying with bonds rated in the Bs would be safer. Ratings of A to AAA are safest.

Also, check the yield on your fund. The median 12-month yield for the high yield category is 5.6 percent, said Bush. If your fund is yielding more than that, you are taking on significant risks.

Morningstar analyst Christine Benz notes that some institutions, like pension funds, donít hold any high-yield bonds. They argue that high-yield bonds ó which act more like stocks than bonds ó donít add anything to portfolios.