‘Safe Haven’ Bonds Have Become a Minefield

There is more bad news for individuals who invest in bonds.

Bond defaults have hit record highs in the first half of 1991, and some respected debt-rating firms are becoming more pessimistic about the ability of additional bond issuers to keep paying on their debts.

What that means to investors is that there is an increasing likelihood that a steady stream of their interest income could be cut off. If interest payments are resumed after the issuer’s bankruptcy or reorganization, the rate of interest could be pared.

For many investors this is a shocking reversal of fortune.

Bonds, which are essentially IOUs from companies, cities, states and the U.S. government, have been considered a safe haven for those looking for a conservative investment that could provide steady monthly income.

These securities can often be purchased in denominations as small as $1,000 and often offer investment yields that are at least somewhat more generous than deposit rates offered by most healthy banks and thrifts. (The investment yield is determined by looking at the rate of interest after taxes.)

Until the past few years, they also held few risks. The vast majority of bond issuers were willing and able to pay on their debt. But during the 1980s, borrowing by individuals, companies and governments soared. And now, bond issuers and investors are paying for that overspending.

Part of this problem, of course, is caused by nation’s ailing economy and probably will improve if the overall economy recovers. Many bond issuers, for example, contend that they would have been able to make payments if consumers had just continued to buy their goods and services at the same rate as before.

But when the recession hit, unemployment soared and consumers--often fearful about their jobs or overextended themselves--cut spending.

That pared the revenues of manufacturers and retailers who survive on selling goods and services to the public. And the woes of consumers and industry filtered down to the government because the government is largely financed by taxes that take a portion of what’s earned by companies and consumers. In the end, it became far more difficult for everyone to pay on their debts.

The result: Moody’s Investors Service says 64 companies defaulted on $12.5 billion in debt during the first half of 1991. That compares to 43 defaults on $10.7 billion in debt a year ago and to only 21 corporate bond defaults worth $3.3 billion in the first half of 1989.

Meanwhile, Standard & Poor’s says financial prospects have deteriorated at 422 companies during the first six months of 1991, which caused the New York-based rating service to downgrade their debt. During the first six months of 1990, S&P; downgraded the debt ratings of only 84 companies.

Those who invested in bonds issued by states, counties and cities have also been hard hit. Municipal bond defaults are hitting all-time highs. Only bonds issued by the U.S. Treasury seem immune from the default problem. But the rates on Treasury bills and bonds are far less generous than those offered by companies, state and local governments.

What can bond investors do?

Those who are already affected by a default have few choices. They can wait the problems out or sell to brokers and investors interested in distressed bonds. Be aware, though, that these investors are generally willing to pay only fire sale prices--sometimes just pennies on the dollar.

At times, investors are wise to accept even these sorry rates. But certainly not always. Companies often have salable assets even when they go into bankruptcy. And, depending on which kind of bond you own, your rights to those assets may be exceptionally good.

Those who own a company’s debt almost always have a greater claim to that firm’s assets than those who own its stock. Assuming that the value is there, you may be able to recover a substantial amount of your investment even if the firm is liquidated.

However, it might not be easy. Many investors falsely assume that assets will be evenly and fairly distributed when a company is liquidated, when, in fact, there is no such guarantee. If the company you invested in is in bankruptcy, make sure you get a copy of its reorganization or liquidation plan to see how you will be treated. Also consider joining other bondholders to ensure that your interests are protected.

If you are simply attracted to bonds because of their generous yields and are considering buying, investigate before you write the check. Demand a financial statement or an offering circular, for example, and take time to read it.

In some cases, the companies and government entities issuing bonds will clearly disclose that they will be able to meet their debt payments only if revenues increase. And that may be an unreasonable assumption in these difficult economic times.

Also look to see if any other organization is backing the bonds. In some cases, bond payments will be guaranteed by a private insurer if the normal revenues needed to pay on the bonds are insufficient.