Junk Bond Funds Offer The Most Attractive Yield For Investors: A Look At The Western Asset High Income Fund II

Jun.19.12 | About: Western Asset (HIX)

High yield bonds (junk bonds) "can't get no respect" even though they have some of the highest yields today without a lot of additional risk. Junk bonds have lower ratings because of greater risk than on investment grade bonds. But junk bond funds have fairly good track records since they became popular in the late 1980s even though the recessions in the early 1990s and 2000 were very difficult with high default rates for junk bonds. High default rates caused junk bond funds to slash dividends; many cuts were more than 50%. But the funds got through the 2008 recession in better shape with limited dividends cuts (if any). And the other years have generally seen flattish dividends with occasional year end extras.

Unfortunately there is no good index to illustrate performance of junk bond funds, so I will illustrate with one I know very well. Years ago I bought shares in a predecessor fund that was merged into Western Asset High Income Fund II (NYSE:HIX). This is a diversified, closed-end management investment company managed by Legg Mason. My original investment has more than doubled, attributable to reinvested dividends over the years. Its chart below shows the stock has held up well during a time when some of the best stocks of traditional companies declined.

Western Asset High Income Fund --- 10 years

Click to enlargePerformance has been largely sideways with one major sell-off in the 2008-9 financial meltdown when yields on these funds skyrocketed to more than 25%. Rational thinking returned and stock prices were bid up, reducing yields to traditional levels around 8%. The flat performance of HIX indicates a higher degree of stability than many associate with junk bond funds.

The major variable expense causing dividend cuts is the default rate on debt held. Defaults have been low in recent years, presently at historically low levels under 2%. Default rates are forecasted to be 1.5% for 2012 and 2% for 2013, well below the historical long term average above 4%.

Dividends and their evaluations (derived yields) determine stock prices for junk bond funds. In late 2007 HIX paid a monthly dividend of 8¢ which was raised to 8½¢ in December (start of the recession). The dividend was increased to 9½¢ in June 2009 and then gradually reduced to the current rate of 8¼¢ (which will be paid through August). This record provides more consistency than is appreciated.

The data for HIX is used only for illustrative purposes, not as a specific recommendation for the stock. Etfconnect.com is a site listing pretty much all closed-end funds (CEFs) investing in debts with a wide choice of comparable funds, some with yields upwards of 10% and even higher.

Generally low yields suggest market tops. But periods of these relatively low yields on junk bond funds have largely prevailed over the long term. Another key measure to understand valuations is the yield spread over the 10 year Treasury bond. It is over 600 basis points, above the lowest spread of 450 basis points. As long as Treasury interest rates remain low, and the Federal Reserve intends to keep rates at record low levels for at least 2 more years, present yields can continue for years (as in the past) without raising red flags about market tops. By definition, junk bond funds should only represent a small portion of a portfolio. But in a time when the vast majority of investments have much lower yields, investors willing to accept added risk associated with junk bond funds will be attracted to them for high income.

Disclosure: I am long HIX.