High yields in an unloved sector

A Fidelity fund manager focuses on the higher-quality side of junk bonds.

By TheStockAdvisors Oct 26, 2011 1:15PM
By Jim Lowell, Fidelity Investor

Investors have been selling out of junk bonds and junk bond funds based on fears of potential outcomes rather than on known fundamentals.

I'm now recommending Fidelity High Income (SPHIX) to capitalize on this currently unloved and, I think, undervalued portion of the bond market.

So what are we buying with this fund? High-yield bonds, or junk bonds, are fixed-income securities rated BB or below.

The term "junk" is apt, as these bonds are issued by companies whose default is a very real risk. Some are indeed junky and always have been.

Others are good companies that, for one reason or another, have taken on enough debt that ratings agencies and investors think they could miss an interest payment, or several, and could be unable to pay off their bonds at maturity.

On average, 5% of the bonds in the junk, or non-investment-grade, market default each year. At times, defaults have spiked to 10% to 15%, but it's rare.

One difference between high-yield bonds and other bonds is that in the high-yield market, prices are often more attuned to the state of the economy than simply to interest rates.

If the economy is heading for trouble, junk bonds typically lose value because of the potential for defaults. In a strong junk bond market, though that often also translates into lower yields.

As in the stock market, there are higher quality junk bonds and lower quality junk bonds.

Manager Fred Hoff, who runs the fund, builds a higher-quality, high-yield portfolio by focusing on bonds for which he has greater confidence in the issuer's ability to repay debt. He studiously avoids investing in the riskier segments of the market.

Default rates are very low, corporations have improved balance sheets, and we continue to be in a slow-growth, not no-growth, environment.

Anything is possible, but today, SPHIX offers an attractive yield at a spread over risk-free assets that have historically signaled higher relative returns down the road.

Junk bond funds tend to be more economically sensitive than interest rate sensitive, so you'd want to own them as an economy is recovering.

For the current climate where growth is being discounted to the point of no return, I think SPHIX will help elevate our portfolios.

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1Comment
Oct 26, 2011 5:00PM
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I have bought and held high yield bond funds from for years and they have paid off extremely well.
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