Junk Bond Slide Raises Red Flag

Wall Street was rattled Tuesday by further signs of trouble in the high-yield bond market, including an analysis of corporate credit quality that revived memories of the junk bond debacle of a decade ago.

Moody’s Investors Service, a leading credit-rating agency, reported that the credit quality of debt-laden U.S. companies is in its steepest plunge since 1989--when bankruptcies were surging and the junk bond market began to collapse--and may get worse.

The report stated publicly what some investors have already been whispering: Problems with junk bond portfolios may be stalking some investment banks.

Tuesday, shares of Morgan Stanley Dean Witter & Co. fell more than 10% on speculation that the brokerage faces losses from steep declines in the market value of high-yield telecommunications company bonds. Morgan Stanley shares fell $8.75 to $74.50.

The concerns have been fueled by the resignation last week of Dwight Sipprelle, co-head of global high-yield bond trading, underwriting and sales after 16 years at the firm. His departure followed lower-than-expected third-quarter earnings, due partly to losses on high-yield debt, including ICG Communications Inc. bonds, which are now trading at about 18 cents on the dollar as investors have fled the securities.

A spokesman for Morgan Stanley said rumors of losses have been “greatly exaggerated.”

Perhaps hoping to head off similar speculation, Deutsche Bank on Tuesday reassured its workers that all is well in its junk bond unit. Edson Mitchell, the Deutsche Bank board member responsible for global markets and equities, told employees in an internal memo that the junk bond-related woes of others could be a boon for the German bank.

Deutsche Banc Alex. Brown, the U.S. investment-banking unit of Deutsche Bank, was the No. 7 U.S. underwriter of junk-rated bonds in the first nine months of the year, according to Thomson Financial Securities Data.

Deutsche Bank’s American depositary receipts slipped $2.38 to $79.63 a share Tuesday, the same day the bank offered to acquire National Discount Brokers Group Inc. for $49 a share--almost double the current price.

In its report, Moody’s attributed the slide in the credit quality of corporate borrowers--meaning, in their ability to repay their debts--largely to a drop in consumer spending, a strong dollar and companies’ inability to pass on high labor and energy costs.

These factors, it said, may have helped trigger the recent spate of warnings by companies of lower-than-expected earnings.

“We might actually enjoy a brief respite from the current deceleration of domestic spending, but the risks, looking ahead, are still great enough to preserve significant downside risks for the high-yield market,” said John Lonski, Moody’s chief economist.

“I don’t think the slumping Nasdaq market, with earnings worries, is doing the high-yield market any good,” he added. The technology-heavy Nasdaq has fallen 23% since Sept. 1.

Moody’s said ratings for “speculative-grade,” or junk-rated U.S. companies, which carry ratings of “Ba1” or lower, were battered in the third quarter.

These companies suffered 75 rating downgrades affecting $44.3 billion of debt; there were just 29 upgrades affecting $19.1 billion. Not since 1989 has the ratio of debt downgraded to debt upgraded been higher, Moody’s said.

Year-to-date, downgrades outpaced upgrades by a 3-to-1 margin, Moody’s said. In contrast, last year there were 43 upgrades for every 100 downgrades, and the dollar amount upgraded actually slightly outpaced the amount downgraded.

Junk bonds yield more than higher quality bonds to compensate for extra risk. Still, a jump in junk bond defaults over the last year has caused many investors to shy away from the securities.

With their market values sinking, junk bonds have posted the worst returns of all U.S. bond sectors this year. Since early September, the yield on the KDP junk bond index--which moves in the opposite direction of the prices of the bonds--has spiked from 10.70% to 11.33%, reflecting growing investor anxiety about the bonds.

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Junkier Junk

Yields on corporate junk bonds have jumped in recent weeks, reflecting growing investor anxiety about the economy and about borrowers’ ability to repay their debts.

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Weekly closes and latest yield for the KDP index of 100 major junk bonds

Tuesday: 11.33%

Source: Bloomberg News