Warning signs are flashing for junk-bond investors

NEW YORK (AP) -- Junk bonds have been strong investments since the recession, and investors continue to pile into the market. But fund managers say they're looking less attractive. Many are taking a step back and urging investors at least to temper their expectations.

The big run for junk bonds came as investors clamored for better interest rates. The Federal Reserve has helped keep interest rates low, which gives the economy a boost but also limits the interest income generated by bonds. To make up for that, investors have turned to bonds from companies with lower credit ratings that carry a higher risk of default.

Junk bonds are also called high-yield bonds because they have to pay higher interest rates to make up for their increased risk. Demand has been so strong that the price of junk bonds has jumped significantly. That's making many investors question if their yields are still attractive.

"High-yield (bonds look) pretty pricey," says Kris Kowal, a managing director who oversees $10 billion in investments at DuPont Capital Management. Junk bond yields are close to 5 percent, down from greater than 20 percent during the financial crisis of 2008. "Do you want to lend money to some of these high-yield companies at 5 percent? I don't know."

As investments in Kowal's junk-bond portfolio mature, he's moving much of the money to other parts of the bond market.

To be sure, last year many fund managers also called for caution, yet junk-bond funds delivered more gains. The average high-yield bond mutual fund returned 5.5 percent over the last 12 months, making it the leader among the 32 types of bond funds that Morningstar tracks.

Bond-fund managers also say that junk bonds continue to look more attractive than other types of bonds. And defaults have not been a problem: The default rate was 1.7 percent last month, up slightly from 1.6 percent in March, which was its lowest level since the financial crisis.

"We still like high-yield relative to other sectors," says Matt Pallai, portfolio manager at the JPMorgan Multi-Sector Income fund. "Prices are just very high. There's not a lot of room for error."

With prices so high and volatility low, Pallai says the junk-bond market could quickly turn jumpy if confronted with any surprises. That's one reason his fund has cut the amount it has in junk bonds over the last couple months.

Junk bonds are down to 40 percent of the portfolio from 50 percent, and most of the money that the fund has pulled from high-yield bonds has gone into cash.

Among the warning signs that are flashing for high-yield bonds:

— INVESTORS ARE EARNING LESS OF A PREMIUM OVER SAFER BONDS.

When considering a bond, investors don't look at just its yield. They also check how its yield measures up to a Treasury bond maturing around the same time.

Junk bonds have recently offered about 3.7 percentage points more in yield than similar Treasurys. That's lower than the average difference of 4.3 percentage points over the last 12 months. Over the last five years, the average spread has been 6 percentage points.

That means investors are getting paid less of a premium to take on the added risk of default that a junk bond carries.

— PROTECTIONS FOR INVESTORS ARE WEAKER.

When companies issue bonds, they agree to certain restrictions with investors. These restrictions, which lawyers call covenants, can put a cap on how much debt a company can take on, for example.

Since 2011, Moody's has been keeping a monthly tally of how strong the protections are for investors who buy bonds issued by junk-rated companies. The rise in demand for junk bonds means that companies with low credit ratings have generally faced more lax restrictions when borrowing money.

Moody's measure of covenant quality fell to a record low in February, though it has improved a shade since then.

Despite the increased warning signs, investors continue to pour into junk bonds. High-yield bond mutual funds took in a net $5.3 billion through the first four months of this year. That's more than triple the $1.5 billion investors put into intermediate-term bond funds, the largest bond-fund category with triple the assets of junk-bond funds.

In coming years, those investors can likely expect lower returns than high-yield bonds have offered. Over the last five years, high-yield bond mutual funds have posted an average annual return of 13.6 percent. Looking ahead, a more fair expectation is closer to the current yield that the bonds offer, say 5 percent, according to managers.

Investors should also keep in mind that junk bonds can have sharp swings due to their increased risk. In 2008, for example, the average high-yield mutual fund lost 26.4 percent, compared with a 4.7 percent drop for intermediate-term bond funds.