EDITORIAL: THERE’S A GOOD REASON THEY CALL IT JUNK

One man’s junk is another man’s treasure — and so it may be with junk bonds. But to whom will the treasure belong? That’s the question financial planners and advisers should be asking on behalf of their clients as they consider the multitude of new closed-end junk bond funds being offered.

As InvestmentNews reporter Michael Fritz revealed last week, underwriters raised $3.4 billion in 10 new closed-end funds in the first five months of this year — more than triple the $1.1 billion raised in eight offerings all last year. More than 50 brokerages sold pieces of the action in an $800 million high-yield (or junk) bond fund offering in April.

Will all the treasure wind up in the hands of the wirehouses offering the funds at the expense of unwary individual investors stretching for yield? Or will the investors come out ahead?

The answer depends on timing. Yes, junk bonds and junk bond funds can be appropriate investments offering extra increments of yield. But planners and clients should look carefully, even warily, at the latest offerings.

First, there is great uncertainty about the economy. No two economists seem to agree on an outlook for the next six months.

Some see the economy continuing strong, with the danger that inflation will pick up because of tightening labor markets. That could cause the Federal Reserve to raise interest rates, clobbering junk bonds and junk bond funds. Indeed, Alan Greenspan hinted as much in his comments last week that the U.S. economy’s current performance was the he’s seen in some 50 years — and that it shows no sign of slowing.

Others see the economy being dragged down by the Asian financial crisis, possibly sliding into a recession, causing a surge in corporate failures and junk bond defaults.

Neither prospect is positive for junk bond investors. Only if a third group of economists is right — the economy slows some, but remains basically healthy, with low inflation and stable or slowly declining interest rates — will junk bond investors prosper.

Another reason to look closely at junk bond closed-end funds: The spreads over investment-grade bonds currently are not that great — they may not be nearly enough to compensate for the added risk.

Advisers and their clients would do well to measure the potential risks of stretching for yield through junk against the potential rewards (as well as against a client’s current risk posture and tolerance). Resist the hype that says junk bond funds are golden for everyone. For unwary investors, some junk bond funds could just be junk.