Long-Term Yields on Junk Bonds Outweigh the Risks, Report Says

Will junk bonds collapse in a recession? Or are they a lot less junkier than many people think?

The answer depends on who you ask--or rather, who you ask to study the risky, high-yield instruments.

In the latest study to look at the controversial issue, the prestigious economic forecasting firm of Data Resources Inc. concluded in a report released Tuesday that the fast-growing $180-billion junk bond market is indeed getting a bad rap.

In even a severe recession similar to the devastating 1981-82 downturn, default rates of junk bonds will rise significantly, but not enough to offset their higher yields over Treasury and investment-grade corporate bonds, the firm said.

“We are not saying junk bonds are not risky. There are risks, but the returns are more than adequate to cover them,” said David Wyss, chief economist for Data Resources and principal author of the study. “If you can afford to hold a well-diversified portfolio for a long enough period, it looks like a very attractive investment.”

The study adds that junk bonds are only slightly more risky than many more traditional assets, such as investment-grade corporate bonds, commercial loans and mortgages, and are “substantially” less risky than common stocks.

The report is bound to further intensify the debate over the investment merits of junk bonds. It comes amid widespread investor skittishness about junk bonds, particularly whether a recession will severely hurt profits at corporations that issue the bonds, leading to widespread defaults.

The report also seeks to influence the debate in Congress over whether to curb the ability of savings and loans to invest in junk bonds. Wyss told a Washington press conference that junk bonds have been profitable investments for S&Ls; and restricting those institutions’ ability to invest wouldn’t help them stay solvent or deal with the thrift industry’s actual problems.

The report also is likely to stoke the controversy over the objectivity of academic studies commissioned to research junk bonds.

The Data Resources study was sponsored by the Alliance for Capital Access, a Washington-based trade group representing more than 60 junk bond issuers.

Most previous studies that have been wholly or partially financed by Wall Street interests also have extolled the virtues of junk bonds, saying their higher yields--typically 3.5 percentage points above Treasury securities but currently close to 5 points higher--offset their higher risks.

But less positive were at least two independent studies, one by a Harvard University business professor and two colleagues and another by two professors at the University of Pennsylvania’s Wharton school of business.

The Data Resources study may muddy the debate because it agrees with some less-positive studies showing default rates have been higher than previously estimated by industry cheerleaders such as the investment firm of Drexel Burnham Lambert. But the report concludes that even with these higher default rates, junk bonds remain a sound long-term investment if held in a diversified portfolio and not sold off during slumps.

All of these previous studies looked only at the historic record of junk bond performance and defaults. The Data Resources study claims to be the first to look ahead and estimate what would happen in a recession. The market in its present form has never weathered a full-blown economic downturn, having been much smaller during the 1981-82 recession.

The study estimates how the bonds will perform under four scenarios by calculating the impact of interest rate changes, slowing growth and other factors on corporations issuing the bonds. In three of the scenarios--one assuming a “soft landing” with no recession, one assuming a mild recession lasting two quarters and the third a severe decline--the default rates on junk bonds would average about 2.6% a year, Wyss said.

That is in the range of the current 2% to 3% default rates estimated by most experts. Default rates won’t increase much because lower interest rates would ease the burden of paying off short-term debts, offsetting the negative effect of declining cash flows, Wyss said.

In the worst-case scenario, involving a recession similar to the 1981-82 case when inflation and interest rates continued to rise despite the slowdown, the average annual default rate would rise to close to 4%, Wyss said. Junk bond issuers would not fare as well if interest rates continued to rise.

The report contends that the riskiness of high-yield bonds has not changed significantly over the years.

“The average high-yield issuer is more highly leveraged than a decade ago, but it is also larger and older, both of which factors weigh against default,” the report said. “In addition, the high-yield users tend to be concentrated in less cyclical industries, and are under-represented in the most cyclical industries, especially durable manufacturing.”

Wyss contended that the junk bond default rates predicted in his study did not differ greatly from past default rates measured in a controversial study released earlier this year by Harvard University professor Paul Asquith and two colleagues. The Harvard study claimed that the default rates on bonds issued in 1977 and 1978 averaged 3% per year through 1988.

Asquith, who is moving to the Massachusetts Institute of Technology, declined to comment on the Data Resources study until he could see it. He noted that his study did not attempt to predict the future nor did it comment about whether junk bonds were a good or bad investment.

Wyss defended his work against possible perceptions that its conclusions are biased because it was commissioned by a trade group of junk issuers.

“It’s always a risk when you commission a study that people won’t take it seriously. . . . But we never take anything where we are playing a hired gun. We have to protect our objectivity because we work for every side.”