INVESTMENT OUTLOOK : ASSESSING THE MAJOR MARKETS : A New Look for the Junk Bond Market
After a decade-long advance, the junk bond market hit the skids as the 1980s came to a close.
Prices of these high-yield, high-risk issues plunged in the second half of this year as defaults were announced by Campeau Corp., Resorts International and Integrated Resources. Mutual funds were forced to sell into the slide when they suffered hundreds of millions of dollars in redemptions as investors headed for cover.
And investor fears spread into the new-issue market where potential buyers said “no” to deals such as the multibillion-dollar proposed takeover of Ohio Mattress.
Although junk bonds appear riskier, they are also proving to be more attractive than ever. As prices plummeted, junk bonds were offering unprecedented yields--at times posting rates as high as 9 percentage points over investment grade bonds of similar maturity.
The problems of 1989 are expected to lead to changes in the risk, size and quality of the market in the next decade, increasingly attracting “bottom-fishers” and gamblers who will be buying junk bonds much as they have been buying equities over the years.
Despite declarations in some quarters that “the party’s over,” billions of dollars worth of high-risk, high-yield bonds are still routinely being placed in the private and public markets, which will likely continue, although at a markedly slower pace than the past decade, market professionals said.
“We’re paying for our excesses,” said one trader about the slowdown in the once-hot market.
Market professionals generally agree that in the next decade fewer deals will be completed, and the general quality of those deals will improve.
But increasingly, junk bonds will be bought and sold as though they were risky stocks. And that is where some analysts see opportunities for investors.
“Over the next three years there will be a lot of savvy buyers who will pick through the heap,” said Mark Vaselkiv, vice president of the T. Rowe Price High Yield Fund, a junk bond mutual fund with $1 billion in assets. “In our business, a bond can drop 30% to 40% in value, but it can also rise 30% to 40% in value.”
Vaselkiv said bankruptcy specialists and savvy value investors will begin entering the market, as will other investment managers who will treat junk bonds as an equity investment rather than strictly as a fixed-income security.
A. Michael Lipper, president of New York-based Lipper Analytical Services, which tracks mutual funds, is one adviser encouraging some clients to include junk bonds as part of their equity investments.
Junk bonds, Lipper said, “have near-equity like returns and risk.” He sees junk bonds as “a senior class of equity, not a junior class of debt.”
A junk bond trader at one of the largest Wall Street investment houses said his firm was readying an effort to market junk bonds to managers of stock portfolios.
Lipper and others said the blurring of junk bonds and stocks will get increasingly hazy in the 1990s as more high-yield bond deals include so-called equity kickers. For instance, as an incentive to buyers of the record $4-billion junk bond financing of RJR Nabisco in May, underwriters attached warrants to the bonds, granting holders the option to purchase up to 8% of the company’s stock.
Joe Bencivenga, co-director of research at the investment firm of Drexel Burnham Lambert Inc., said it is too early to establish such a trend. Since the so-called Campeau Crunch hit in September, Bencivenga said, “there’s been $2 billion in deals done and not one with equity attached” to the bonds.
But Bencivenga does see a trend in investors buying junk bonds for their stock portfolios. “If you assume the stock market is at an all-time high, the thing to do is move up from stock to bonds,” even in the same companies, he said.
With last year’s defaults, however, small investors were moving out of junk bonds altogether.
Most small investors play the junk bond market through 90 high-yield mutual funds, which collectively hold $35.3 billion in junk bonds, according to Lipper.
Despite yields as high as 18% on some funds, many posted total returns--yield plus price change--that were negative, according to Morningstar Inc., a mutual fund tracking service.
“Many investors thought they were in just another bond fund,” said Lori Lucas, an analyst with Morningstar in Chicago. “But they are finding out they are in a very high-risk investment.”
Investors should closely examine the quality and total return of the mutual funds before buying.
Lucas said the spread in interest rates among junk issues of similar grading can be more than 8 percentage points apart. For junk bond mutual funds, the spread can be more than 15 percentage points.
Some funds with the highest yields suffered the most from defaults last year, Vaselkiv said.
But some investors may have to stay put for the moment. “It’s a bad time to be selling . . . we could be at the bottom,” Lucas said. “The danger is, it could be a long time before they come back.”
Richard Lehmann, president of the Bond Investors Assn., an investment research service, fears the market may never come back.
“We’re telling people to stay out of the market,” he said. “Those in the market, should get out . . . There’s more bad news to come.”
Lehmann said he believes that the $10 billion of junk bond defaults in 1989 will grow geometrically over the next three to five years, just as new issues grew geometrically during the past three to five years.
“It’s a simple extrapolation,” Lehmann said.
Still, market analysts and traders generally agree that there will be capital available to finance a continuing junk bond market--even though recent federal legislation requires savings and loans to sell their junk bonds by 1992. Currently, S&Ls; hold about $20 billion in junk bonds, or about 10% of the market.
Drexel’s Bencivenga said new money will be coming from pension funds in search of higher returns and foreign investors who have been watching from the sidelines.
And the development of new junk bond instruments could open the market to traditional, high-grade investors.
Drexel is now marketing an investment product called collateralized bond obligations. These are fixed pools of junk bonds that include bonds with a face value greater than the value of the pool. For example, a $150-million issue would be used to back up $100 million in assets in a collateralized bond obligation.
“Individually, they are pretty poor credits,” Bencivenga said. “As a group, they are a pretty good credit.” Through diversification and over-collateralization, these pools have been able to receive investment grade “A” ratings, but they produce a better yield than a typical single “A” bond, Bencivenga said. So far, Drexel has sold $2.2 billion of CBOs and has an additional $2 billion to $3 billion of units on its calendar.
But critics dismiss such developments as ploys by brokers desperate to keep the gravy train on track.
“Greed is always a driving force,” said Lehmann, adding, “the judgment day will come.”
WHO OWNS JUNK BONDS
A breakdown of investors in the high-yield, high-risk bond market as of Dec. 31, 1988.
Insurance Companies: 30%
Securities Dealers: 1%
Mutual Funds and Money Managers: 27%
Savings & Loans: 10%
Foreign Investments: 9%
Pension Funds: 15%
Corporations: 3%
Individuals: 5%
Source: Drexel Burnham Lambert
AN ERA OF GROWTH
In the 1980s, junk bonds grew dramatically, especially in the last four years. As a percentage of the rapidly growing corporate bond market, however, junk bond growth has flattened.
Percent of corporate bond market
1982: 13% 1983: 13% 1984: 16% 1985: 18% 1986: 23% 1987: 24% 1988: 25% 1989*: 25% * as of July 31
Source: Drexel Burnham Lambert
