Q. A recent article promoted the acquisition of junk bonds. The basic rationale offered was that the level of returns (about 13 percent) offsets the risk of default (2 percent, historically), offering a projected long term net of 11 percent. Of course, there is the possibility of a zero percent return, short term, because of a temporary increase in defaults. I always thought junk bonds were a crapshoot but maybe the name has me psyched out. What's your take on this?

---A&ME, by e-mail

A. The basic premise for junk bond funds is an interesting one: build a large enough portfolio to spread the default risk and your net return will be higher than the return on securities with less risk. In addition, top-notch portfolio managers will avoid the big disasters.

Unfortunately, it hasn't worked that way. Late in 1999 the drums were beating with the same message: it was a good time to buy because junk bonds were yielding a near record spread over Treasury securities.

What happened? The average junk bond fund returned 1.70 percent last year. Principal losses nearly exceeded heady interest income. Even 11 Federal Reserve rate cuts did nothing to boost values. In my book, this fund category has had its chance--- they are a good story but a poor investment.

You can understand why I say this by comparing performance and other figures for junk bond funds with the average intermediate maturity government securities fund and a popular, low cost bond index fund. As you can see from the table below, the average government bond fund has done better than the average junk bond fund in the last year, three years, five years, and fifteen years. Junk bonds narrowly beat the average government fund by 0.35 percent over the last ten years--- but assumed nearly twice as much risk to do it. An index fund representing the entire bond market, Vanguard Total Bond Market Index Fund, beat the average junk bond fund over every time period, lost less in 1994, has nearly half the risk, and costs less than one-sixth to manage.
Comparing Junk Bond Funds with No Credit Risk Funds
Item 1 yr 3 yrs 5 yrs 10 yrs. 15 yrs. 1994 10 yr. Std Dev. Exp Ratio
Junk Bonds 1.70 -1.01 1.31 6.56 6.58 -2.99 7.59 1.29
Int. Govt. 6.84 5.33 6.33 6.21 7.18 -3.42 3.92 1.15
Vanguard Total Bond Market 8.43 6.23 7.33 7.15 7.82 -2.66 3.95 0.22
Source: Morningstar Principia Pro, December 31, 2001 data; all figures in percent.
Q. In 1991 I read a recommendation to buy various preferred bonds issued by insurance companies. I have earned over 8 percent on these bonds for the last ten years. They trade as stocks and were recently called. My broker noticed the call and presented me with other preferreds that yield about 7.25 percent.

My question is this: these are strong, viable companies--- why do they have to pay so much to borrow money? Is this something too good to be true?

---C.W., by e-mail from Dallas

A. Investing in preferred shares isn't "too good to be true." These shares offer strong yields because of their position in the creditor line if anything goes wrong. In the event of financial problems, the bankers and bondholders get paid first. If there is anything left, it goes to the preferred shareholders.

If there is anything left after that, it goes to the common shareholders.

In addition, when a corporation issues a bond it is making a promise to return your money at a specific time--- the maturity of the bond. A preferred stock share, however, has no maturity date, though some may be called.

Put it all together and you can expect that preferred shares will provide a relatively high yield.

So why do companies issue preferred shares?

Bonds need the buffer of the equity investment--- someone who shares the risk of the business. By floating preferred shares a company can increase the shareholder equity needed to support its bonds.

While the most secure preferreds offer yields in the area of 6 percent, it is relatively easy to find yields of 7 and 8 percent.