Junk Bonds Weathering Weak Market
If stock prices keep sliding, are junk bonds sure to follow?
The market for such high risk, high-yield corporate bonds has held up remarkably well over the past week, despite Wall Street’s sudden gloom over the economy.
But some junk pros say investors are showing the first signs of worry.
One junk bond trader in Los Angeles describes buy-and-sell activity as “soft and mushy” in recent days. “Everybody’s nervous,” this trader said.
Coincidentally, a load of new junk issues are being sold this week--a rarity since 1989. So far, investors are eager buyers:
* On Tuesday, Los Angeles-based electrical equipment maker Magnetek Inc. sold $125 million in seven-year bonds yielding 10.75% annually.
* On Monday, banana giant Chiquita Brands sold $250 million in 12-year bonds at 9.80%.
Those large companies may not fit many investors’ image of a “junk” company, but the truth is that only a select few big American firms are rated “investment grade.” That technically leaves all others various shades of junk--a market that totals between $200 billion and $300 billion in corporate bonds, depending on whom you ask.
In the now-infamous crash of 1990, the value of such non-investment-grade bonds plunged. The demise of junk brokerage Drexel Burnham Lambert, bond-dumping by insolvent S&Ls; and the recession sparked by the Persian Gulf crisis all converged to destroy many investors’ confidence in junk companies and thus in their bonds.
Result: The average junk bond mutual fund slumped 11% in 1990, and many individual junk bond issues lost 30% to 50% of their value.
This year, the fortunes of the junk market have completely reversed. Buyers have poured in, realizing that 1990’s selling was grossly overdone and that most of the firms are surviving.
The average junk mutual fund gained 34% (interest plus capital gains) between Jan. 1 and Oct. 31, dazzling investors and luring many. In October alone, investors poured $602 million into junk bond funds versus $283 million a year earlier.
Some junk fund managers say that’s the problem now--that too many of this year’s junk buyers are “fair weather” investors who could abandon the market in a hurry if the economy sinks.
“To me, things are getting too wild,” says Bill Veronda, manager of the $106-million Financial Programs High Yield fund in Denver. “Too many people are just chasing for yields.”
Indeed, that’s still the lure of junk bonds--the highest yields you can find anywhere. Even though those yields have fallen as trust in the issuers has rebounded, an index of junk bonds compiled by brokerage Donaldson, Lufkin & Jenrette Securities still sports a yield of 15.09%.
More typically, though, junk bonds (and junk bond funds) now yield in the range of 10% to 12%.
Are those yields worth the risk, if the U.S. economy is headed for a new recession?
It’s key to note that junk bond values depend in part on the stock market. The 1991 bull market has allowed many firms to sell new stock, raising cash then used to pay off debt--junk bonds, bank debt or other IOUs. As such junk issuers bolster their finances with new capital, their bonds become less risky--and more sought-after.
So if stock prices continue to plunge and new-stock deals become impossible, that will remove a key element of support for junk bonds.
Still, bond owners’ biggest fear is default--when a firm can’t pay its bond interest anymore. And on that front, many experts believe the worst is past, even if the economy slumps anew.
“Most of the junk companies that were going to go bust have already done so,” argues Richard Lehmann, director of the Bond Investors Assn. research group in Miami. Junk bond defaults totaled $24.5 billion for all of 1990, and $11 billion in this year’s first quarter, he says. But in the third quarter, new defaults fell to $4.1 billion.
What’s more, many junk mutual funds believe they’ve hedged against a new bout of economic trouble by staying away from the riskiest bonds. “None of us ever expected the economy to be very strong,” says Ellis Bigelow, manager of the American Capital High Yield fund in Houston.
Nonetheless, if you plan to stay in junk bonds, you’d better be a long-term investor now. Recession talk could begin to sting, and investors who have made big gains in junk this year could start taking profits. This might be a rough market in ’92.
But if the events of the last two years have taught a lesson, it’s that most companies do in fact pay their bills. In the long run, the junk market will probably prove to be exactly what it was advertised to be: A market with greater risk, but with greater returns to compensate.
