Junk? Bunk!
Marilyn Cohen, Forbes Magazine, 07.21.03

Should the soaring high-yield total return chart below scare the bejesus out of you? And how. The high-yield market has been on a red-hot tear since its October 2002 low. Junk bond funds took in more money during 2003's first quarter than in all of 2002. Take notice: Many personal finance magazines have begun touting high-yield bond funds, meaning the funds are peaking. Do not listen to this optimistic garbage.

Christopher Garman, Merrill Lynch's high-yield guru, compares today's narrowing spreads to his high-yield proprietary model. His finding: "This is the second-largest recorded overvaluation signal on record. Largely a product of low and declining capacity utilization." The first overvaluation was in April 2002. Over the next six months the sector had a total return of -12% because of rising defaults.

Like dot-com stocks in 1999, high-yield bonds are priced for perfection. There is no room for disappointment. But anyone who has looked at bankruptcy filings knows there is no such thing as perfection among heavily leveraged borrowers.

Many newly issued junk bonds carry yields only a sliver higher than bonds of investment grade (BBB and better). Take, for example, Norampac, a cyclical containerboard producer that is rated Ba2 by Moody's and BB+ by Standard & Poor's. Its new ten-year bond recently came to market at a 6.75% yield. That was a measly 3.3-percentage-point spread over the ten-year Treasury. Normally such spreads are 4.5 to 5.0 points.

Primed by money lured out of money market funds, which are paying less than 1%, and a public willing again to take a little risk, lots of junk bond prices have advanced on nothing but ether. Some companies have seen enough improvement in their fundamentals to justify the price rebound. Most have not.

Overvalued issues with bloated balance sheets abound, such as Charter Communications, the cable operator; MeriStar Hospitality, a hotel real estate investment trust; and automotive-interior outfit Collins & Aikman.

One of Charter Communications' largest and most liquid issues, the 8.625% due Apr. 1, 2009, has gone from 43 cents on the dollar at the end of last year to 73 now--with a $300 million injection of new capital but only a modicum of fundamental business improvement. We are talking about a company with $17 billion in debt and negative cash flow from operations last year.

Mutual funds are supposed to give you diversification, but junk funds don't always deliver this. They too often diversify by issue and not by industry. Thus investors in most high-yield funds during the stock market bubble saw their money disintegrate because the portfolios had 20% to 30% telecom allocations, with heavy doses of such gems as Global Crossing and Covad.

If you have a big chunk of your portfolio in junk bond funds, take some profits. The masses soon will be fleeing.

That's not to say, however, that all junk is bad. You can move into some good individual issues with your profits. One place to look: among companies that have already been through the fire. They have endured financial distress and made changes to their businesses and/or balance sheets.

One is Rite Aid, which harbors a sordid past. But that history changed in 1999 with new management. During the company's turnaround Rite Aid paid down debt, remodeled stores, freshened inventories and increased pharmacy sales. I like the 7.125s due Jan. 15, 2007, trading at 99 for a 7.45% yield to maturity.

Imax Theaters is considerably dicier than Rite Aid, but you get a yield commensurate with the risk. The 7.875s due Dec. 1, 2005 trade at 98 for an 8.8% yield to maturity. The gigantic screen theater company is now showing blockbuster Matrix Reloaded, with Matrix Revolution coming in the fall. This is the first time mainstream live-action films can be viewed in Imax format, thereby reaching a mass-market audience.

Considerably safer: J.C. Penney, a retail turnaround story. The 6s due May 1, 2006 trade at par for a 6% yield to maturity. Latest 12-month earnings of $1.68 billion before interest and taxes covered interest expense 4.3 times.

My junk warning siren may be early. Markets always tend to overstretch themselves. But this run-up is overdone.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at http://www.forbes.com/search/results.jhtml?RD=DM&MT=marilyn%2Bcohen&date=&author=&sort=.