Federal Reserve Board Chairman Alan Greenspan may believe there are no systemic signs of failure in the $200 billion junk bond market, but some financial experts are not so sure.
Junk bond prices have fallen steadily since September in the wake of higher interest rates, lower corporate earnings and the subsequent defaults by key junk bond financiers.With every wave of bad news, more investors are scurrying to call their brokers and mutual fund companies for reassurance or a quick sale.
By the week before last, the collapse of Drexel Burnham Lambert Inc., a prime junk bond market maker, caused further erosion but less of an impact than many financial experts were expecting.
Now, individual investors are unsure whether to sell what they have left, to buy more or stay with the status quo. Here are answers to some common questions about junk bonds that might help with those decisions.
How do I know if I hold junk bonds?
You may not. Mutual fund prospectuses call them "high yield corporate bonds." If the price of the bond fund you have been holding has eroded steadily since September, chances are it is invested at least partially in junk bonds, according to Ferris Baker Watts broker Jean Kahl.
If you are unsure, call your broker or mutual fund company and ask.
Are all junk bonds alike?
No, some are riskier than others. The worst are those issued by companies that already have filed for bankruptcy or otherwise indicated they will default on their debt. However, some speculative investors believe even these bonds can be a good deal if you buy in at 10 cents on the dollar and eventually receive 20 cents in the bankruptcy settlement.
The best "junk bonds" are those issued by respectable companies with enough cash on hand to minimize their debts and enough market makers (the players who are willing to sell when everybody else is buying or buy when everyone else is selling) to ensure an orderly flow of sales for those bonds.
When Drexel pulled out of the market, Kahl said, some thinly traded bond issues lost their chief market maker.
Unless a firm has several companies that "make a market" in its bonds, investors can find their holdings without any support when they want to sell them.
Are all junk bond mutual funds alike?
No. Those that are better managed have been anticipating problems and accumulating cash. Kahl says it is best if your fund is holding at least 30 percent of its funds in cash and short-term money market instruments.
At T. Rowe Price, vice president Steve Norwitz says the firm's no-loan, high-yield fund has been holding about 8 percent to 10 percent in cash. That is more than enough to repay investors pulling out and to buy junk bond bargains that crop up, he says.
Has the market hit bottom?
Emotionally it has, but in reality many analysts think that the market still can go down further.
Any big emotional selloff of junk bonds and junk bond funds probably has occurred, and the people still left holding these investments have for the most part signified their willingness to ride with the market for a while.
But prospects for slowed economic growth, reduced corporate earnings and higher interest rates all mean that there could be more defaults before the market recovers.
"There is still a lot of potential bad news. This is nowhere near played out," says Kahl.
"We may be nearing the bottom. There are further risks," says Norwitz, "but at these yield spreads there are some very attractive investments."
What should investors do? Those who bought junk bonds because they needed the income generated by the high yields will be the least disappointed. Unless the bonds they hold are in default, the high yields will continue, and even improve with the falling prices.
Investors should protect themselves by being in mutual funds with large diversified portfolios of bonds, run by fund managers who have been accumulating cash and buying bonds issued in large lots by healthy companies with a lot of underwriting.
But for those people investing for the long term and looking for growth, the risks of junk bonds may be larger than the returns justify. "In that case, just sell," Kahl advises.