Another Fund Favorite Falls on Tough Times

It takes only a handful of blunders in this climate to ruin the record of what for decades has been a fine mutual fund. Northeast Investors Trust, one of the best junk bond funds for most of its nearly 60 years, is a sad example.

Northeast lost a total of $110 million on bonds issued by Donald Trump, Delphi and Kaiser Aluminum, according to the fund's latest filings with the Securities and Exchange Commission. That's disastrous for a fund that has withered from nearly $2 billion of assets in 2004 to $500 million today. Since Northeast (symbol NTHEX) is less diversified than the usual high-yield bond fund, wipeouts crush its performance more drastically than that of its rivals.

How badly has Northeast done? It lost 37% in 2008 and 10% in 2009 through March 3. Both numbers place it in the bottom 10% of its category. Northeast also found its way into the bottom 10% of junk funds in 2007, when it eked out a gain of 0.2%. And although Northeast's yield, based on its March 3 net asset value of $3.60 per share, is 14.4%, its NAV is down so much that the fat payout doesn't come close to offsetting the price declines.

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Results weren't always so dismal at this small, independent Boston investment-management firm. In the 14-year period from 1993 through 2006, for instance, the fund ranked in the top 10% of its peer group five times and in the top half nine times. Over that period, Northeast returned an annualized 8.4%, an average of nearly one full percentage point per year ahead of the typical junk-bond fund.

That Northeast should do well in good times shouldn't be surprising. That's because of the strategy employed by co-manager Ernest Monrad, who has worked for the fund since 1960, and his son, Bruce, who has been running the fund with his father since 1989. The Monrads have always been willing to take on more credit risk than the typical junk-bond fund. That is, they have been willing to buy lower-quality or unrated bonds, which usually pay more interest than better-quality IOUs. Also, Northeast can use leverage (that is, borrow money to enhance returns) and buy preferred stocks, convertible bonds and common stocks.

In boom times, such flexibility enables Northeast to perform better than the more conservative high-yield funds sponsored by such firms as T. Rowe Price and Vanguard. But the reverse is true when financial markets sour and many highly indebted industries go into a tailspin.

You can't fault the Monrads for excessive greed. They never spread themselves too thinly by offering separate accounts or launching a raft of other funds (although their shop does offer a stock fund, called Northeast Investors Growth). The junk fund's management fee (part of overall expenses) is a fair 0.50% per year. Northeast levies no sales load. Ernest and Bruce each has more than $2 million of his own money in Northeast, so they're motivated to improve performance. The losses hurt them doubly because declining assets slash their company's income from management fees.

The question now is whether there's much these well-meaning fellows can do to stop the rot. In the short run, the problem is that 26% of Northeast's holdings are rated CCC or worse, a level that implies a high probability of default. The proportion is less than 10% at more-conservative (and, of late, better-performing) junk funds such as Payden High Income (PYHRX) and Vanguard High Yield Corporate (VWEHX).

Moreover, as of year-end 2008, Northeast carried $100 million in debt, close to 20% of its assets, the highest ratio of debt it's allowed to have. The managers used some of this debt to meet shareholder redemptions without having to sell devalued securities into a falling (or even frozen) market. But it still hurts performance. One-third of Northeast's expense ratio of 1% represents the interest paid on these borrowings.We left two messages for Bruce Monrad asking for comment but got no response.