Junk Funds Dabble in Best of the Worst

--line of death is 6 times multiple -- By LARRY LIGHT As the economic slump deepens and more companies teeter at the edge of bankruptcy, a number of junk-fund managers are buying riskier bonds. How to explain this paradox? They are essentially betting that the junk-bond market overshot when it plummeted in December. Now, by buying discriminately, junk-fund managers think they can scoop up debt that won't default in a shrinking economy. Managers are starting to add bonds in previously shunned sectors such as autos, retail and gambling. In December, they sat on the sidelines or bought into less risky areas such as wireless, energy and health care. "It's time to stop playing defense," says Mark Vaselkiv, manager of T. Rowe Price High-Yield fund, which is up 5.1% thus far this year after losing 24.5% last year, typical for a junk fund then. "I see a lot of opportunities." Renewed buying by managers is one reason the high-yield market has rebounded from its darkest days in December. Two months ago, the average junk yield had shot up to 18% from around 9% in June, says KDP Advisors, a junk research firm. December's yield spiral was partly driven by hedge funds that sold their junk bonds to cash out fleeing investors, which sent junk prices crashing. Now, though, that panic selling appears to have mostly passed. Right before New Year's Day, the $6 billion U.S. government bailout of ailing GMAC LLC, the auto-financing company, heartened junk investors. Prices rose, and thus the average yield on below-investment-grade bonds fell, to 13%. As a result, a lot of the once-suffering high-yield funds are now posting positive returns. They rose an average 4.7% last month even as the average stock fund lost 7.4%. The managers have more money to work with because investors are getting more optimistic about junk, too. In January, they invested 3.5% more money in junk funds than the previous month, according to AMG Data Services. The terrain remains treacherous. Overall, credit quality in the high-yield arena is getting worse rather than better. While the 4% default rate last year was around junk's normal level, Standard & Poor's projects that, because of the recession, it will hit 13.9% in 2009. Almost half of the market resides in double-B-rated bond issues, the highest junk rating. But the compelling values created by the junk market's rout are enticing many managers into single-B-rated bond issues and below. Junk bonds are issued by the most debt-laden companies. The ones rated single-B or below pay the highest yields, and the best of those stand to appreciate once the market wakes up to their strengths. The trick is to find them. Some managers, like Thomas Price of Wells Fargo Advantage High Income, are going for B-rated credits yet are avoiding the next rung down, triple-C. "The likelihood of bonds surviving there is lower," he says. One way managers like to pick bonds is to subject them to a stress test. The ideal they look for: issuers whose total debt is three times or less earnings before interest, taxes, depreciation and amortization. If the multiple is around 4.5, that is still good. What managers call "the line of death" is six times. Thus, casino owner Harrah's Entertainment Inc., whose multiple is 8.2, and retailer Michaels Stores Inc., at seven, are way too risky for all but the most intrepid of value hunters. Mr. Vaselkiv holds bonds in the dicey retail sector -- from Sears Holdings Corp., maturing in 2011. This retailer, like others, has seen same-store sales plunge lately, and its bond prices have been punished. The Sears bond now changes hands for around 72 cents on the dollar. But the debt/Ebitda multiple is just 2.0. So Mr. Vaselkiv's bet is that the price will bounce back and meanwhile he will collect its rich yield, 21.5%. He is confident that Sears will weather the storm. Sears's Cash "They've got $1.1 billion in cash and they've been buying back debt," he says. The cash on hand is enough to buy back the 2011 bonds, and by then he figures the company will have an easier time raising capital. He isn't always wedded to the multiple if a bond is near-term and it has other things going for it. Consider the Ford Motor Credit bonds that his fund owns -- it doesn't even have a multiple because its cash flow is negative. Since last fall, its bonds have risen in price from 52 cents on the dollar to around 89. Like its parent, the auto-financing entity has refused direct federal bailout money, saying it is strong enough stand alone. But Mr. Vaselkiv believes the company is strong enough to survive on its own, but if things get worse, it will accept federal bailout money. Another positive factor: Ford Motor Credit is in talks with the Federal Deposit Insurance Corp. about opening a subsidiary bank, which would allow it to receive cheaper financing. For Matt Philo, manager of MainStay High Yield Corporate Bond fund, good value can be found in Penn National Gaming Inc., a casino operator whose bonds due 2015 go for 83 cents on the dollar. One attraction is its debt multiple of just three times cash flow. Another is that it has no properties in Las Vegas. "Vegas is overbuilt, and it's gaming companies there that will be hit hard," he reasons. Distressed Bets Low prices are exceedingly tempting. So some managers are dabbling in so-called distressed plays: companies on the edge of restructuring or in it. Fred Hoff, manager of Fidelity High Income, has bought senior notes of Charter Communications Inc., a highly leveraged cable-TV provider that in mid-January missed interest payments on several bonds, although not on the senior notes. Mr. Hoff figures that these notes, which trade at 84 cents on the dollar and yield about 14%, will continue to pay interest. Charter's $900 million in cash will see to that, he says. He adds that, in any restructuring, the junior debt will be wiped out, not the senior notes. Still, some managers remain hunkered down and aren't reaching for extra risk, fearing that the recession will harm the low end of the credit ranks hard and in unexpected ways. Thomas Huggins of Eaton Vance Income Fund of Boston has 21% of his holdings below single-B. "I'm not adding to this," he says. Write to Larry Light at larry.light@wsj.com