Where Risk Hits Home

By Christine Gorman

Ask most small investors if they would put money in junk bonds, and they would probably respond with a hearty no. But anyone who has a deposit in a savings and loan, holds an annuity from an insurance company, is vested in a pension plan, makes contributions to certain mutual funds or participates in a 401(k) retirement program probably has some exposure to the risk of junk bonds. In most cases, that is no cause for alarm. But in a few instances, investors have good reason to be wary.

Despite their name, junk bonds -- more politely known as high-yield, high- risk bonds -- often serve a useful financial purpose. Companies that are too small to issue blue-chip bonds can use high-yield securities to raise money for expansion. Because their debt is considered riskier than the bonds of their larger brethren, the junk issuers must pay five percentage points or more above the prime rate.

During most of the decade, junk-bond defaults ran at an annual rate of only 2% to 3%. But now that the economy is shaky, some analysts predict that defaults could hit 10% to 15% of the $200 billion market this year.

While S&Ls own 7% of all junk bonds, depositors will be shielded from loss if a thrift runs into trouble because the Government insures deposits up to $100,000. But the junk-bond slump could increase the already enormous taxpayer cost of the Bush Administration's S&L bailout package (anywhere from $160 billion to $300 billion), since the Government will have to sell the securities at a loss.

Mutual funds own 30% of all junk bonds. Funds that promise "high income" or "high yield" are generally the ones that invest heavily in junk. Most prudent fund managers have been switching during the past year to more creditworthy issues, including Kroger and Fort Howard Paper. Yet the depressed market value of most junk securities means that fund investors who sell out now "will take some pretty substantial losses," according to Brian Ternoey, an employee-benefits consultant in Princeton, N.J., who advises clients to wait for the market to rebound.

Insurance companies own another 30% of junk bonds. While most firms concentrate no more than 8% of their assets in the securities, a few have gone beyond the safety zone. Junk bonds account for more than 35% of the $19 billion in assets held by First Executive of Los Angeles.The firm's heavy reliance on junk may make it difficult for First Executive to meet its obligations, thus posing a danger to retirement funds that the company manages.

Pension-fund holders should beware if their employer has terminated its retirement plan -- usually to tap excess cash -- and replaced it with an annuity, a kind of insurance policy that pays income to the company's retirees on a regular basis. Revlon got its hands on $100 million in 1986, when it closed out its pension fund and bought an $85 million annuity -- from First Executive. A safety net protects employees in most states, which have agencies that insure private pension funds against default. The Federal Government guarantees many pensions as well. But it is uncertain how much protection this affords employees whose pension funds have been replaced by annuities. A few annuity holders could find their benefits drastically reduced.

A number of 401(k) retirement plans may also be at risk. About 40% of 401(k) contributions are invested in guaranteed investment contracts -- obligations that pay back a fixed rate of return on the principal. Since insurance companies that sell GICs compete to offer the highest yield, some firms put the money into junk bonds. For 401(k) holders, the trouble is that the guarantee applies only to the interest. If a GIC seller runs into junk-bond trouble, the principal could be jeopardized.

The best approach is to put retirement money into a range of solid companies. Prudential, for example, has invested only 2% of its assets in junk, while Aetna holds just 0.5%.

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CREDIT: [TMFONT 1 d #666666 d {Source: Drexel Burnham Lambert}]CAPTION: WHO OWNS JUNK BONDS

With reporting by Andrew Webb/Chicago and James Willwerth/Los Angeles