Word: bond
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Since 1985 junk-bond funds have returned an average annual 6.3%, according to fund tracker Morningstar. That's nowhere near the 14% from stocks in the same period. But it's unlikely that stocks will keep up such a torrid pace. Their long-run return is about 10% a year, and even that mark may be hard to achieve for a while. Yes, stocks have fallen sharply and are cheaper. But their recovery will be hampered because they remain expensive relative to earnings, dividends and book value...
...Junk bonds, on the other hand, have rarely been so cheap. They carry an average yield of about 12.25%, vs. about 5% for the benchmark 10-year Treasury bond. The difference between those yields, known as the spread, represents a hefty premium of 7.25 percentage points. The long-run average spread of junk over T-bonds is just...
...reason for the higher spread is that we're in a recession and junk-bond default rates have been rising well beyond the average 3.5% a year. Nearly 1 in 10 junk-bond issues has stopped paying interest, and Martin Fridson, chief high-yield strategist at Merrill Lynch, predicts the rate will rise further next year--probably narrowly topping the record default rate of 10.3%, in 1991. But that will be the worst of it, he says, and he notes that "the last time we had record default rates, we had record returns...
...with the onset of a recession, the average junk-bond fund fell 10%. Then it surged 37%, 18% and 19% over the next three years. During a slowdown in 1994, junk-bond funds fell 4% but then rallied more than 12% in each of the next three years...
This pattern makes sense. Investors look ahead to recovery, when the default rate will drop and make the lush yields on junk bonds more secure. That leads investors to bid up junk-bond prices, resulting in a capital gain. "We've already seen some junk bonds rally," says John Fenn, head of high-yield investments at J.P. Morgan Fleming Asset Management. Next year, he believes, junk bonds will deliver on their eye-popping 12% yields and produce a capital-gain kicker worth an additional 5% to 10%--for a total return of about...