You've heard it before: Junk bonds are a terrific buy. Certainly, it's hard to pass up fixed-income investments yielding 13.6% at a time when Treasury bond yields are the skimpiest in decades.
The tricky part is figuring out whether junk bonds--officially called "high-yield securities"--are a savvy value play or a sucker's trap. After all, there are good reasons why junk bonds are yielding 10.4 percentage points more than comparable Treasuries, the widest yield gap since the 1991 recession: rising bankruptcies, deteriorating credit, and fear of a double-dip recession.
Still, Martin Fridson, chief high-yield strategist at Merrill Lynch, gives junk the thumbs up: "The yields more than compensate for the risk." Why listen to Fridson? Because he's usually right.
When jittery investors bailed out of junk bonds last year in the wake of September 11, Fridson counseled his clients--mainly large institutional investors--to do the opposite. Those who listened were rewarded: High-yield bond prices surged 6% in the last three months of 2001.
The strategist subsequently turned bearish in April. His rationale: Junk-bond mutual funds--the way most individuals invest in this market--were getting huge inflows early in the year, a time when few new high-yield securities were being issued. The imbalance, he says, pushed prices up to artificially high levels. Since then, junk bonds have lost 12% of their value. Another smart call: advising investors to lighten up on junk from May, 2000, through December, 2000, a period when they lost 4.4% of their value.
The cornerstone of Fridson's research is a quantitative valuation model, which takes in such variables as corporate default rates, money supply, capacity-utilization rates, and the consumer price index. Now, Fridson's model suggests that junk-bond yields are a full percentage point higher than they ought to be. That's what makes the bonds a buy.
The 50-year-old Harvard University grad (he earned a BA in history and an MBA there) has been researching the junk-bond market since the 1980s heyday of Michael Milken and Drexel Burnham Lambert--and doing a first-rate job of it. For nine years, Institutional Investor has named Fridson and his team the top high-yield strategists on Wall Street in its poll of the pros.
Right out of B-school, Fridson went to work as a bond trader. In 1980, he joined PaineWebber and switched to bond research. Fridson was drawn to the then-new area of high-yield research and pursued that at several other investment banks. In 1989, he moved to Merrill and assumed the post he has today. As if the job weren't enough work, Fridson also has written five investment books, including How to Be a Billionaire: Proven Strategies from the Titans of Wealth ($24.95; John Wiley & Sons), and his light verse has been published in The New York Times and The Wall Street Journal.
Fridson's institutional clients often dart in and out of junk bonds, but the strategist argues that buy-and-hold investors will likely make money over the next few years. Here's why: In the boom years of the late 1990s, almost any company could raise money in the junk-bond market--including lots of startup telecoms. As a result, the default rate for junk bonds soared from 2% in 1998 to 9.6% recently. Now, only the more solid companies among high-yield issuers are able to sell new debt.
This situation bodes well for the junk-bond market, says Fridson. With fewer and higher-quality borrowers, the default rate is likely to drop over the next three years. As defaults wane, Fridson figures, investors will likely view the junk-bond market as a less risky place, and they'll bid up prices. Thus, investors who buy junk bonds today stand to earn not just double-digit yields but also capital appreciation.
Betting on junk bonds is no sure thing. But listening to a market pro like Fridson is one way to stack the odds in your favor. By Susan Scherreik