Junk bonds seen as stock alternative for bargain hunters

It’s understandable that bargain hunters are drawn to beaten-down stocks, but they may be doing themselves a disservice if they don’t also consider junk bonds.

In order for stocks to make a serious recovery, conditions must first change in the credit markets, said Sandy Rufenacht, chief investment officer and principal owner of Three Peaks Capital Management in Greenwood Village, Colo.

Bond spreads — the difference in yield between bonds — have to tighten, and that tightening is likely to start with high-yield bonds, said Mr. Rufenacht, who managed the Janus High-Yield Fund, offered by Janus Capital Management of Denver, until July 2003. At that point, he and the Janus high-yield team set out to launch Three Peaks Capital Management.

Additionally, the junk bond market is a good place for bottom-fishing investors, because historically, high-yield bonds tend to sell off first but also are the first to rally, leading the broader market, said Mr. Rufenacht, who manages the $15.4 million Aquila Three Peaks High Income Fund for Aquila Asset Management of New York.

“One of the markets that does snap back faster is high-yield,” he said. “It could offer the opportunity to be up substantially more than stocks.”

There’s no doubt that junk bonds have a better risk-reward profile than stocks, said Jack Ablin, chief investment officer of Harris Private Bank, a unit of Harris Bankcorp Inc. of Chicago. They form a class of senior debt that has priority with respect to interest and principal over other classes of debt and over all classes of equity from the same issuer.

SOME UNCONVINCED

But some financial advisers said they are unconvinced that now is the time to be investing in high-yield.

Portfolio managers he has talked with are most excited about investment-grade bonds, said Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., an Amherst, N.Y., financial advisory firm with $220 million in assets.

Irrational fear has driven yields on such bonds to historically high levels, meaning investors are being handsomely rewarded for what little risk they are taking, he said.

It makes going out further on the risk spectrum seem unnecessary, Mr. Schroeder said.

“We’re happy not to take the extra risk,” he said.

And it’s difficult to gauge accurately what that risk may be, said Patrick Hanratty, a managing director with Capital Advisors Ltd., a Shaker Heights, Ohio-based firm with $550 million under management.

Before the credit crisis, the major ratings agencies gave their highest grades to securities containing debt backed by subprime mortgages. Those securities are now at the center of the crisis, Mr. Hanratty said.

“What’s junk anymore?” he said.

It’s a valid concern, Mr. Rufenacht said. It’s why he is careful about which bonds he buys.

Currently, Mr. Hanratty’s seeing a lot of value in short-duration bonds rated double-B. Bonds rated double-B-plus and below are considered speculative investments.

Some of the bonds Mr. Hanratty likes are from such companies as The DirecTV Group Inc., an El Segundo, Calif., television service provider, funeral services provider Carriage Services Inc. of Houston and supermarket chain Supervalu Inc. of Eden Prairie, Minn.

The assumption that such junk bonds may do well when markets finally recover makes perfect sense, said Milton Ezrati, a senior economist and market strategist at Lord Abbett & Co. LLC in Jersey City, N.J.

In fact, Lord Abbett is recommending that investors stock up on high-yield bonds, he said.

It’s a mistake, however, to pit junk bonds against stocks, Mr. Ezrati said.

“I don’t see it as either/or,” he said.

E-mail David Hoffman at [email protected].