Junk Bond Default Rate Higher Than Believed, Study Says

A controversial new study by an investor group contends that high-yield junk bonds have defaulted at an annual rate of 11.2% this decade, a pace more than three times higher than shown in previous studies.

To compensate for such risk, the group said, investors should demand that junk bonds yield at least 5.5 percentage points more than U.S. Treasury securities, far higher than the historic 3.5-point average and about even with the spread in current trading.

The study, released Tuesday by the Bond Investors Assn.--a nonprofit research group in Miami Lakes, Fla., that claims 14,000 investor members--may stoke the growing controversy about junk bonds and whether they adequately compensate investors for added risk.

Not surprisingly, the study drew immediate criticism from the Alliance for Capital Access, a chief trade group for junk bond issuers.

“The bottom line is that the math doesn’t work,” said David Aylward, executive director for the alliance. He contended that if the study’s conclusions were true, and that a 5.5-point premium were needed just to do better than Treasuries, investors in junk bonds should have fared worse in the past decade because they were not being adequately compensated for their risk.

Instead, he contended, junk bonds have earned higher total returns than any other form of fixed-income investment in the past few years.

“Saying that most investors in high-yield bonds lost money is absolutely wrong,” Aylward said. However, he did not question the accuracy of the raw data used by the bond association.

Junk bonds, which hardly existed at all until the early 1980s, often are issued by young corporations unable to issue investment-grade bonds, or by companies seeking to finance takeovers.

Previous studies, including two made public within the past year by Harvard University researcher Paul Asquith and by the economic research firm of Data Resources, have shown the annual default rate to be between 2% and 3%.

The Data Resources study concluded that investors have been more than adequately compensated for their added risk.

However, the Data Resources study and some other previous studies were financed by the securities industry and thus were biased toward junk bonds, said C. Richard Lehmann, president of the Bond Investors Assn. and author of the new study.

More important, he said, they used only a limited universe of corporate bonds, Lehmann said.

For example, some of the studies excluded bonds that were unrated or unfollowed by the major rating agencies, he said.

“Each has been selective in what they were measuring,” Lehmann said. “As a result, that has led to some misleading statistics.”

Lehmann said his study included all bond defaults since 1980, from what he claims to be the nation’s most extensive database on corporate bond issuance and defaults.

He said 631 corporate bond issues totaling $30.1 billion have defaulted since 1980, of which 70.1%, or $21.1 billion, were junk bonds.

Between 1982 and 1987, he said, about $14 billion of $119 billion in bonds issued originally as junk bonds defaulted.

He also found that investors recovered an average of 49.6 cents on the dollar for their defaulted bonds. That, coupled with the 11.2% default rate, means that investors should demand at least a 5.5 percentage point yield premium on junk issues over Treasuries.

“God help us if we have a recession,” Lehmann added, noting that the default rate would likely rise in an economic downturn and that many of the more recently issued junk bonds have financed leveraged buyouts and other transactions that have not weathered a full-blown economic downturn.

JUNK BONDS’ SHARE OF DEFAULTS

First set of columns below shows the number of corporate bond defaults in the year indicated and their total value. The second set shows the number and value of junk bond defaults. In some years, junk bonds accounted for the total number of defaults.

Total Defaults Junk Bond Defaults Year Issues $ in millions Issues $ in millions 1980 17 308 15 278 1981 12 44 12 44 1982 35 884 31 759 1983 25 466 25 466 1984 31 656 31 656 1985 51 1,731 48 1,447 1986 121 4,489 116 4,181 1987 118 10,426 96 3,675 1988 109 4,582 97 3,987 1989 112 6,601 103 5,644

Source: Bond Investors Assn.