A High-Yield Rebound

Happily, if history is any guide, buyers will return with a vengeance in 2008.

Just before the last major credit crunch struck in 1998, high tech was the market’s favorite flavor. The sector suffered mightily that year as fears of global recession peaked. But worries faded, investors again set their sights on making money and tech exploded upward in 1999.

What high tech was to the 1990s, high yield is to the current decade, with nowhere near the same risk level. Provided their underlying businesses stay on track, bashed-up big payers will come roaring back when the fear of a global meltdown subsides.

So-called junk (or non-investment grade) bonds and preferred stocks have been among the market’s worst casualties this year and therefore stand to rebound strongly. Spreads for B-rated paper have exploded to more than 5 percentage points, with commensurate losses of principal.

To be sure, default risk has grown. That’s why our individual selections hail from recession-resistant industries like electric power (AES Corp Preferred C and Consumers Power Preferred B), telecom (Comcast Corp Preferred B) and defense (Northrop Grumman Preferred B), or else low-risk REIT franchises (Mid-America Apartment Preferred H and Simon Properties Preferred J). They’ll keep paying even if we do see a recession.

Despite recent losses, the same is true of our high-yield funds. Only 14 percent of Flaherty & Crumrine Preferred Income Fund is rated below investment grade by both S&P and Moody’s. And although ING Prime Rate Trust and open-end fund Northeast Investors Trust hold almost entirely non-investment grade senior debt, including financials, they’re exceptionally diversified.

Of the trio, Northeast is by far the top performer this year and the most conservative now. That’s mainly because it’s an open-end fund and always trades at net asset value (NAV). In contrast, closed-end funds such as Flaherty and ING have swung from premiums to discounts to NAV. Northeast management has also learned a thing or two about navigating rough markets in its 57-year history and is well outpacing its competition.

Once today’s recession fears fade, all three funds will be off to the races. In the meantime, their holdings are cheap and solid. Despite investor worries, Flaherty & Crumrine Preferred Income Fund, ING Prime Rate Trust and Northeast Investors Trust are buys for those who don’t already own them.

Income Portfolio