Will Ailing Junk Bonds Be Able to Follow Rebounding Stocks?
Can a stock market rebound fix what’s wrong with the corporate junk bond market?
In recent weeks junk bond values have crumbled, as many junk mutual fund owners know too well: The average junk fund’s year-to-date loss has widened to 11% through Monday, according to fund tracker Morningstar Inc. The average return was a negative 3% at the end of September. Those returns are interest earnings minus principal loss.
As the economy has weakened, many investors have shied away from speculative bonds. That has depressed their prices, in turn driving yields on junk issues up sharply. The average junk bond yield has soared past 12%, the highest level since 1992, according to KDP Investment Advisors.
Historically, the junk market has rallied, and fallen, in tandem with the stock market--which is why Tuesday’s big Wall Street gains have raised hopes for junk. Also, a cut in interest rates by the Federal Reserve in 2001, as hinted by Fed Chairman Alan Greenspan, would be expected to help junk bonds.
But some analysts warn that a fast recovery for the junk market may not be on the horizon, for a number of reasons:
* High--and rising--default rates. Moody’s Investors Service issued a report Tuesday warning that junk bond defaults will continue to surge next year. Moody’s forecast a 6% default rate for junk issues this year, versus a historical annual norm of 4.6%, and said the rate will rise to 9.1% in the next 12 months as more corporate issuers have trouble paying their bills.
Many businesses, particularly in the dynamic telecom sector, expanded too fast and borrowed too much in the late 1990s, and now aren’t able to generate the money to repay their debts, analysts say.
And if the U.S. economy lands hard or slides into recession, the peak in junk default rates may be nowhere in sight, they add.
“Unfortunately, I cannot state that the worst is over,” said Moody’s economist John Lonski.
* Net redemptions from junk mutual funds. Junk funds have suffered 11 straight weeks of net cash outflows as investors have fled, according to AMG Data Services. That trend has cranked up the selling pressure in the junk market as portfolio managers liquidate securities to meet redemptions.
* Still-ailing equities. Tuesday’s ferocious Nasdaq rally offered tentative relief to junk investors. If the rebound continues, more indebted companies may be able to raise capital by selling new stock next year, giving them more breathing room with their debts.
“But it will take more than a one-day rally,” said Nate Levy, high-yield fund manager at T. Rowe Price Associates. “The capital markets have been closed for a while now, and people are going to want to see some follow-through before they open them up again. The high-yield market is going to be looking for companies to raise equity first.”
Still, some junk bond pros say investors should start looking at opportunities in the junk market, with yields at eight-year highs.
The “spread” between junk-bond yields and U.S. Treasury bond yields is near record levels. Yields on the lowest-rated junk bonds--in other words, the riskiest bonds--average a whopping 23 percentage points above Treasury yields of comparable maturities. Normally, that difference is about 8.25 points, said Richard Lehmann, publisher of the Income Securities Advisor, a bond newsletter.
With the average junk issue in the KDP index yielding 12.3%, that’s nearly 7 percentage points more than 10-year Treasuries pay.
The spreads are “a clear signal we’ve hit bottom,” Lehmann said. “High-yield bonds are a screaming buy. The economic fundamentals for that spread to be there are simply not there.”
He believes that the junk market is seeing “selective” buying already, noting that yields on BB-rated bonds, the top-rated tier in the junk category, fell in November even as yields on lower-rated bonds soared as investors shunned the riskiest issues.
Lehmann also argues that the default spike has been overblown by the media and is “part of the normal cycle” after heavy junk-bond issuance.
Even Lonski agrees that “long-term investors able to wait out this storm could realize attractive returns, at least over the next three to five years.”
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Bad Year for Junk Bonds
Junk, or high-yield, corporate bond mutual funds have had an abysmal year so far in 2000, amid soaring default rates by troubled bond issuers. Total returns for the average junk bond fund each year since 1990 (total returns are interest earnings plus or minus any change in principal value):
Source: Morningstar Inc.
