Junk-Bond Funds Look Like Losers in New Economy.

IF your high-yield bond mutual fund has been a disappointment lately, put some of the blame on the Internet and the "New Economy."

I know, that's the excuse everybody uses these days when an investment doesn't deliver.

But it makes sense as a reason why so-called junk-bond funds have struggled in a period of strong economic growth -- when traditional logic says they ought to be prospering.

"Rapid change and dramatic growth are not a bondholder's friend," says famed bond fund manager Bill Gross in his latest commentary on the Web site of Pacific Investment Management Co., at www.pimcofunds.com.

The recent results of junk-bond funds back him up. The Bloomberg average of more than 500 high-yield bond funds has lost 1.8 percent over the past year. In the past three years, it has averaged a modest 4.1 percent annual return.

As Scott Berry, an analyst at Morningstar Inc. points out, that's a money market fund-size payoff without the peace and quiet you get from money funds.

Junk bonds have been struggling since the Asian debt crisis in 1998, when investors everywhere took a soul-searching look at credit risk. This struck at junk bonds' perennial weak point -- extra uncertainty about the issuers' ability to pay their debts.

Bravery in the face of credit risk hasn't been the same ever since.

In theory, confidence should be getting much stronger now, with the U.S. economy galloping ahead at 5 percent to 6 percent annual growth rates and the rest of the world looking much perkier as well.

Sure, the Federal Reserve has pushed short-term interest rates higher as a brake on rapid growth -- but that would stand to hurt top-quality bonds more than junk bonds, which are often said to be "equity-like" with their close links to the economic health of their issuers.

The problem now, says Gross, is that in the new-age Internet scheme of things, junk bonds aren't so equity-like after all.

"The accepted wisdom in the stock market is that high-tech/Net stocks will produce a few big winners and many losers," he says. That "lottery" logic might work in favor of stocks, he notes, but it just doesn't add up for bonds.

Because successful junk-bond investments still pay back just 100 cents on the dollar at maturity, junk-bond portfolios need many winners to offset the harm inflicted by even a few that go bust. That doesn't fit with the Internet model at all.

Another thing that gives high-yield bond investors the heebie-jeebies, Gross says, is the prospect that corporate profits in general might get harder to come by in an Internet world.

The Internet intensifies price competition by making comparison-shopping easier than ever before. Businesses find it tougher and tougher to raise prices, even if the cost of attracting and keeping skilled workers keeps going up.

As Gross puts it, "If the consumer, as opposed to business, becomes the ultimate beneficiary of technology-based efficiencies, then corporate bond quality will suffer."

The beauty (and the misery) of markets is that by the time you've thought something like this through, it's already reflected in security prices. Ah, but if the concerns are overblown, well, maybe there are bargains to be found.

"There's tremendous opportunity in the high-yield market," says Margaret Patel, manager of the $23 million Pioneer High Yield Fund, the best performer over the past year among 508 junk-bond funds tracked by Bloomberg with a 27 percent return. "It's very cheap."

Patel says some of the forces hurting the high-yield market lately have been technical. "Junk returns have paled in comparison to equities," she says, encouraging investors to pour money into aggressive stock funds, and to withdraw money steadily from high-yield bond funds.

These outflows leave fund managers without the cash to buy bonds, and may force them to sell some of their holdings. While that deepens the market's funk, it also can tilt the long-term odds in favor of the brave few who step up and buy.

That's how it was in 1990, the junk-bond market's darkest hour. Over the 10 years since, Morningstar Inc.'s average of high-yield bond funds has returned a generous 10.2 percent a year, leaving general bond funds, at 7.3 percent, in the dust.

Even so, if you're attracted to junk-bond funds now, remind yourself that this isn't 1990 all over again. There's something new to be reckoned with, the Internet.

Chet Currier is a columnist for Bloomberg News.

Rare Success Story Sprang From April Turmoil

Mutual fund investors, like beachcombers, make some of their most interesting discoveries after a storm.

That's how I happened on the Longleaf Partners Fund the other day. I was checking Bloomberg Fund Performance data for funds that held up well in April during the great tech wreck.

Longleaf Partners is no secret. It has been in business since 1987, boasts $3.2 billion in assets, and has gotten its share of ink. In 1998; Money Magazine's Jason Zweig celebrated it and its three sister funds, managed by Southeastern Asset Management of Memphis, as "the best mutual fund family in America."

Since then, though Longleaf Partners Fund has been in a slump along with many other bargain-hunting "value" funds. Its concentrated portfolio of two dozen stocks, not a single one of them from the "technology" industries, limped to a: 2.2 percent gain in 1999, trailing the Standard & Poor's 500 Index by almost 19 percentage points.

In the first quarter of this year, the fund fell 5.4 percent. But in April, it gained 5.3 percent while all the broad market averages dropped. For the year-to-date, Longleaf Partners has fallen 2.5 percent and the S&P 500 Was lost 3.7 percent.

On one important characteristic of any fund, diversification, Longleaf Partners comes up short. Managers Mason Hawkins, Staley Gates and John Buford listed just 24 holdings at the end of 1999, and a single stock made up 16.4 percent of the fund.

That stock, Waste Management Inc., had a lot to do with the fund's poor performance last year and in the first quarter of 2000, plunging 71 percent over that stretch. Sure enough, it rallied 17 percent in April to boost that month's results.

On other criteria, though, Longleaf Partners stands tall. Expenses are low, there's no 12b-1 plan skimming distribution costs out of the fund. And Southeastern Asset Management employees are required to keep all their equity investments in. the firm's funds.

The fund's long-term performance record remains solid, with a 15 percent annual return since April 1987.

With its concentrated holdings, "the fund isn't right for everyone," Christopher Traulsen, an analyst at Morningstar Inc., says. But "it is good at what it does."