Corporate ‘clunkers’ turn to gold for yield-hungry investors

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Wall Street has had its own wildly successful version of ‘cash for clunkers’ going since spring. It’s known as the junk bond market.

When I last wrote about the junk market, on July 27, the average annualized yield on an index of 100 junk issues had just tumbled through the 10% threshold as investors continued to pile into the bonds.

Now, not quite two weeks later, the yield on that index is on the verge of dropping below 9%. It stood at 9.02% on Thursday, the lowest since May 2008.

In this cash-for-clunkers exercise, you don’t get cash -- you give it, to buy bonds of firms that may variously qualify as clunkers: companies that often are heavily in debt and, in some cases, face serious risk of being unable to pay their creditors what they owe them.

Through July, 187 such companies worldwide had defaulted on their bonds, up from 50 in the same period of 2008, according to Standard & Poor’s.

Amid the credit crisis last fall most investors wouldn’t touch junk bonds. As the securities’ prices plunged, average yields on the bonds rocketed toward 20%.

But since spring, with rising hopes for an economic recovery, the junk market has rallied dramatically as investors have poured back in to grab rich yields. And prices of the lowest-quality bonds have rallied the most, pushing their yields down sharply, as Bloomberg News details in this story.

The average junk bond mutual fund now is up 31.6% year-to-date, counting interest earnings and principal gain, compared with a 16% return for the average domestic stock fund, according to Reuters/Lipper data.

Kingman Penniman, head of junk-bond research firm KDP Investment Advisors in Montpelier, Vt., notes that the market is notorious for attracting momentum-chasing traders. That can make for steep rallies -- and deep sell-offs.

Still, he thinks that a lot of yield-hungry conservative investors have stayed away from the junk market but would dearly like to get in at some point, if the economy continues to show signs of bottoming. ‘I think there is a floor there’ for bond prices, he said -- which means a ceiling for yields.

Veteran junk investor Martin Fridson of Fridson Investment Advisors in New York says that, despite the fear of rising defaults, the numbers have been going down in recent months as credit markets have improved, allowing some companies to refinance debt. There were 26 bond defaults worldwide in March, but just 14 in July, according to S&P.

Of course, that trend could reverse if the economy is headed for a double-dip recession, meaning a recovery in the next few months followed by another slump in 2010. But for now, ‘A lot of companies have dodged the bullet’ of default, Fridson said.

Like Penniman, Fridson sees many investors waiting on the sidelines. ‘One group says, ‘It’s too early to buy.’ The other says, ‘I guess we missed it,’ ‘ Fridson said.

In theory, at least, that’s money that should be itching to move into the junk market on any sell-off, if investors can hang onto the hope that the worst of the recession is past.

-- Tom Petruno