Junk Bond Scare Makes Investors More Cautious : Many Wonder if Increasing Debt Burden Is Hurting Firms’ Ability to Compete

Although price declines for high-yield junk bonds subsided Thursday after a violent selloff the day before, this week’s rout shows that the $200-billion junk market has entered a new era of increasing risk and volatility, analysts said.

Accordingly, investors have become much more picky about which junk issues they will buy, and they are demanding higher yields over safer Treasury securities to justify the risks. The “spread” between junk bond yields and those on Treasuries has widened to well over 5 percentage points, compared to 4.2 points last year.

“The more of these types of scares that we have, the more cautious investors are going to be,” said Michael Singer, director of research at R. D. Smith & Co., a New York firm that specializes in securities of troubled companies.

In addition, investors are no longer worried just about a possible recession and how that would depress the profits of junk bond issuers. They are also worried about the increasing debt burdens that many issuers have taken on, and how those borrowings are impairing these companies’ ability to compete even without a recession.

Some Market Share Lost

Indeed, investors are increasingly wary of junk bonds from issuers such as retailing giant Campeau Corp., which must rely on asset sales and optimistic revenue increases to pay interest on those bonds. Campeau’s disclosure this week that it faces a cash crunch, due in part to disappointing sales growth and other woes, set its Allied Stores and Federated Department Stores bonds plummeting Wednesday and Thursday.

Prices of bonds of other retailers, as well as health-care and financial services firms, have also been hit hard, analyst Singer said. Investors fear that their asset sales and cash flows will be inadequate. Meanwhile, some are losing market share to rivals with less debt that are better able to finance expansions and other competitive moves.

“With these difficulties now, who knows what will happen when a recession finally hits,” said John Lonski, senior economist at Moody’s Investors Service, a chief bond rating firm. “You’ve really never experienced a recession with your corporate sector as leveraged as it is today.”

The junk bond worries have also added a sharp dose of caution to the market for leveraged buyouts. Several troubled junk bond issuers, including Campeau, boosted their debts through junk bonds used to finance LBOs.

‘Starting to Collapse’

Some analysts also contend that the market is less stable because of the absence of former Drexel Burnham Lambert junk bond chief Michael Milken, who resigned under terms of Drexel’s guilty plea to securities law violations.

“Milken used to dress up troubled issues, restructuring and refinancing them so that everyone went away happy,” said C. Richard Lehmann, president of the Bond Investors Assn. in Miami Lakes, Fla. “Since Milken stepped away, there’s been no one there to hold the house of cards together, and it’s starting to collapse.”

Indeed, investors have some justifications for their belief that the stakes are higher in junk bonds. The default rate on junk bonds so far this year has nearly doubled last year’s pace. About $8.3 billion worth of junk bonds have defaulted this year, versus $4.8 billion for all of last year, according to the Bond Investors Assn. That represents a default rate of more than 4%, compared to 2% to 3% before, Lehmann said.

“Junk bonds are beginning to earn their name,” he said.

Among the biggest junk defaults this year are issues of American Continental, parent of failed Lincoln Savings & Loan of Irvine; Southmark, a giant Dallas-based limited partnership syndicator; Integrated Resources, a New York financial services concern; Resorts International, the hotel and casino company acquired by entertainer Merv Griffin, and Eastern Airlines, attempting to reorganize through federal bankruptcy proceedings.

Yielded as Much as 25%

Further, some of the more recent defaults have occurred within a year of the bonds being issued, and in some cases even before the first interest payment was due, Lehmann said. Such were the cases with recent junk bonds issued by New York retailer Crazy Eddie, Resorts International, Residential Resources and Multimedia, Lehmann said.

In Thursday’s market action, prices for bonds of Allied Stores and Federated Department Stores fell again sharply as investors continued to reel from news of Campeau’s cash squeeze. A key Federated junk bond fell about 8 points, or $80 for each $1,000 in face value, while the most widely watched Allied junk issue fell about 10 points, one analyst said. The sharp decline meant that the Allied bond yielded as much as 25%, since yields rise when bond prices fall.

News of their declines helped spark greater outflows of money from at least some mutual funds investing in junk bonds. Steven E. Norwitz, spokesman for the T. Rowe Price mutual fund group in Baltimore, said outflows of funds from its high-yield fund were “well above average” Thursday.

However, the declines in the Allied and Federated bonds did not trigger sharp declines in other junk issues Thursday, as they did Wednesday. Junk issues generally fell between 1/2 to 1 points in slow activity, traders said.

“There was not the same panic atmosphere as yesterday,” said James Spirrison, senior vice president at Rodman & Renshaw, a Chicago brokerage.

To be sure, the vast majority of junk issues still remain in good shape, and there was nothing in the news this week to change the financial conditions or prospects of their issuers. Further, this week’s market selloff could very well have been overdone, leading to a surge of buying by bargain hunters attracted by low prices and higher spreads over Treasuries, analysts said.

Have to Be ‘Selective’

“It’s possible we will see some of these issues bounce back,” Moody’s Lonski said.

“As long as you’re selective, there are a lot of good companies issuing junk bonds,” said Daniel Smith, portfolio manager for the Van Kampen Merritt Corporate High-Yield mutual fund, which was buying junk issues selectively on Thursday. “These will continue to be viable markets; they’ve just gotten a lot of bad press recently.”

But more redemptions by investors in junk bond mutual funds could cause further selloffs by forcing those fund managers to unload bonds to pay off investors, Spirrison said. Continued declines might also discourage companies from issuing new junk bonds, he added.