Hot Debate Over High-Yield Bonds
Defaults on corporate junk bonds are at their highest levels in years, and some analysts think there’s much worse to come.
Time to buy?
That’s the big debate on Wall Street and among smaller investors as well. Junk bonds--IOUs issued by companies considered below investment-grade quality--have been very popular with individual investors for much of the last decade, thanks to lucrative yields that now top 10%.
But since mid-1998 the number of junk issuers that have defaulted on their interest payments has risen markedly.
Indeed, defaults by junk issuers are already at the highest levels since the recession of the early 1990s. Some market watchers are predicting that the default rate will continue to rise if the economy continues to slow.
Bond-rating agency Moody’s Investors Service is projecting that defaults in the 12 months ending June 2001 will total more than 8% of bonds outstanding, up from 5.4% so far this year.
That still would be below the 1991 peak, when more than 10% of junk bonds went bad. But the market is far bigger today, so a rising default percentage means many more issues in default: Last year, 108 issues defaulted, Moody’s said. The peak in 1990 was 88 issues. Already this year 65 issues have defaulted.
But Moody’s default forecast is controversial. Such brokerages as Bear Stearns & Co. and Donaldson, Lufkin & Jenrette say that defaults already have leveled off.
Individual investors seem to be taking a fairly optimistic view now. For the first time since last November, junk-bond mutual funds are attracting net cash inflows. In June the funds took in a net $1.6 billion, according to AMG Data Services.
From January through May, by contrast, a net $4.5 billion flowed out of junk funds, as falling bond values depressed returns and caused many investors to seek a safer haven.
What’s attracting small investors now? Junk-bond yields have soared far above yields on Treasury securities and other higher-quality bonds. An index of 100 junk bonds tracked by KDP Investment Advisors now sports an annualized yield of 11.06%. By contrast, a 10-year Treasury note yields 6.04%. So junk pays almost double what Treasuries pay.
The bullish argument for junk bonds is that the wide “spread” between junk yields and other yields represents an overreaction to pessimistic forecasts about defaults.
“It tends to be an all-buy or an all-sell type of market” in which institutional investors react en masse to whatever news is out, making for big price swings, said Richard Lehmann, president of the Bond Investors Assn. in Miami Lakes, Fla.
He thinks that the current market represents “absolutely one of the best buying opportunities” in years--at least, assuming you don’t expect a severe U.S. recession that could cause credit problems across the economy.
Dan Fuss, manager of the Loomis Sayles High-Yield Fund in Boston, agrees that “it’s a great time to buy--but only if you know what you’re doing.” He suggests shying away from bonds of smaller manufacturers in the middle of the supply chain--auto-parts suppliers, for instance--because their labor and materials costs are rising, yet they lack the power to raise prices.
By contrast, bonds of larger auto parts makers such as Federal-Mogul and Dana are reasonable investment risks because of the companies’ size, Fuss said.
Although oil prices are falling again, Fuss also likes energy-industry junk bonds, reasoning that well-managed firms have taken advantage of the jump in energy prices over the last year to shore up their finances and thus are probably better credit risks.
On the flip side, junk bonds of telecommunications companies give some analysts pause.
Bond analyst Aryeh Bourkoff at UBS Warburg in Stamford, Conn., says that there is a “volatile environment” among the telecommunications firms he follows.
Telecom now accounts for more than one-quarter of all new junk-bond issuance. The industry is by nature highly capital-intensive, and the tech-stock crash this spring removed an important source of capital for many firms.
Well managed companies will continue to get financing, but the others will be sold or liquidated, Bourkoff said. He likes bonds of PSINet and Global Crossing.
What’s behind the general rise in junk bond defaults? After all, the economy may have slowed, but not dramatically.
Many recent defaults stem from a period of easy money in late 1997 and early 1998, when corporate earnings were strong, foreign money was pouring into U.S. debt markets and investors generally let down their guard, according to analyst John Lonski at Moody’s.
In the first quarter of 1998 alone, $30 billion of low-rated bonds were issued. Many junk deals that shouldn’t have been done at all are now coming undone, Lonski said. “It’s payback time,” he said.
Junk investors should be aware that the riskier firms tend to be the smaller ones, Lonski said, echoing Fuss’ point about pricing power.
Investors also should be attuned to rating differences within the junk universe. Bonds rated “Ba” by Moody’s have recently fared far better than the next grade down, “Baa,” Lonski said.
Lonski agrees that there may be some good bargains in the junk bond market, but he feels it is “maybe a bit early” to jump in. “A slowdown in [corporate] profitability is underway with the end not in sight,” he said.
Paul Greenberg, head of global high-yield research at Bear Stearns, suggests that investors who want individual bonds stick with large issues from big firms.
Among Greenberg’s recommendations are junk bonds of Sterling Chemicals, Rogers Communications and Gaylord Container.
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Are Junk Bonds Junk
--or Gems?
The number of corporate high-yield bonds--so-called junk issues--that have defaulted on interest payments has surged in the last 18 months, which has caused many investors to shy away from the sector. But many junk bond pros say that current yields on the bonds--which in many cases are in double digits--more than compensate for the risks.
Defaults rise in dollar terms ...
Dollar value of junk bonds defaulting each year
2000 year to date: $14.4 billion
... and as a percentage of bonds outstanding
Number of junk bond issues defaulting as a percentage of junk bonds outstanding, and Moody’s Investors Service’s estimate of the 12-month default rate as of mid-2001:
Estimate for 2001: 8.4%
Source: Moody’s Investors Service
