He takes most of his chances on junk

Investment manager Andrew Cestone specializes in buying high-yield - or junk - bonds for less than they are really worth.

During the week leading up to the Federal Reserve's meeting Sept. 18 on interest rates, Cestone seized such an opportunity.

He spent $30 million on several home builders' bonds "that we felt were beat up to levels that we didn't think were warranted," said Cestone, who oversees $3.1 billion for Evergreen Investments from offices in Center City.

In an interview last week, Cestone would not identify the corporate bonds he bought, because he was thinking about selling them. Evergreen said the total return on those bonds through last Monday was 8.44 percent.

Annualized, "the number looks almost ridiculous," said Cestone, 37, who built a strong reputation in the Philadelphia office of DWS Scudder, the investment arm of Deutsche Bank AG.

But in August 2006, DWS Scudder consolidated its high-yield-bond operations in its offices in New York.

Cestone declined to discuss his departure from DWS, but he stayed in Philadelphia, moving in March to Evergreen Investment's Tattersall Advisory Group as director of high-yield investments. He brought five people from his Deutsche Bank high-yield team with him to Evergreen's offices at 123 S. Broad St.

High-yield bonds are commonly called junk bonds because their issuers' financial conditions tend to be poor or highly leveraged. As a result, those issuers must promise higher returns from their bonds to entice buyers willing to take on the added investment risk.

During Cestone's tenure at DWS, the high-yield funds had impressive returns, said Andrew Gogerty, mutual-fund analyst at Chicago-based Morningstar Inc. "He obviously comes to Evergreen with the wind at his back," Gogerty said.

In the three years preceding Cestone's departure, DWS High Income Trust - the biggest fund Cestone managed - performed better than 90 percent of high-yield rivals, posting a 10.6 percent annualized gain, according to Morningstar.

Since moving to Evergreen, which is a subsidiary of Wachovia Corp., Cestone has expanded his staff, hiring three. He said he planned to add more, including a trader and possibly an additional supporting analyst.

Cestone said he joined Evergreen at an unusual time for the junk-bond market, because the difference in yield between the riskiest class of corporate bonds and U.S. Treasury bonds - which are considered virtually free of default risk - was at an all-time low.

That was because investors - flooded with money from a booming global economy - were charging very little for the extra risk they were assuming in financing companies with high debt loads or unstable businesses.

From the buyer's perspective, junk bonds were expensive.

Cestone and his team considered, but decided not to buy, junk bonds in several recent high-profile leveraged buyouts, such as U.S. Foodservice, Realogy Corp. and Dollar General. They didn't consider them good buys.

Evergreen also lightened up on lower-quality, "CCC"- rated bonds, and boosted holdings of bonds that were close to maturity, and therefore less volatile, to about one third of the portfolio. "It served us well when the sell-off occurred," Cestone said.

From June 8 through July 31, a Thomson Financial index based on prices of high-yield bonds fell 11.2 percent, said Ed Rombach, a derivative-markets analyst with IFR Markets.

But now, Cestone said, bonds seem to be fairly priced, given all the uncertainties in the market.

That means that the vast majority of the bond returns over the next three years will come from interest, rather than from price changes of the sort Cestone took advantage of in the home-building sector last month.

At such a time, Evergreen's bottom-up credit research is key. "It's important to get the income that you're expecting to get" and not lose any money to defaults, Cestone said.