Investors Turning Away From Junk

The junk bond market is living up to its moniker, and then some.

Yields on corporate junk issues have surged in recent weeks, driving down the bonds’ prices and the share values of popular junk mutual funds.

The junk market’s weakness has disappointed many investors who viewed the sector as a smart alternative this year to risking money in the stock market.

The yield on an index of 100 junk issues tracked by KDP Investment Advisors has soared from 10.41% on May 23 to 11.78% as of Friday--even as yields on U.S. Treasury bonds have plummeted.

Analysts say the junk market’s woes stem from a number of troubles. At the top of the list: Wall Street’s latest slump, which has driven key stock indexes close to the three-year lows they hit in September.

Junk bonds--that is, those rated below investment grade--tend to trade more in tandem with equities than with other bonds. That’s because many heavily indebted companies’ chief hope for paying off debt is via new equity sales. If stocks don’t recover, the financial outlook for many junk-rated companies could suffer.

“Clearly we are tied to equities, and as they come down people are re-pricing our bonds,” said Raymond Kennedy, manager of a $13-billion high-yield bond portfolio at Pacific Investment Management Co. in Newport Beach.

Another big problem is mounting supply. The tally of “fallen angels”--companies that drop from investment-grade debt ratings to junk status--continues to rise. That is making the junk arena more of a buyer’s market, experts say.

Moody’s Investors Service said 58 companies worldwide, including Tyco International Ltd., Dean Foods Co. and PanAmSat Corp., have been cut from investment grade to junk this year. That is already close to surpassing the total of 63 fallen angels in the two-year period of 1990-91, during the previous recession, Moody’s said.

“You’ve had a big jump in the number of junk bonds because of the downgrades,” said John Lonski, chief economist at Moody’s in New York, which estimates the size of the junk bond market at about $575 billion. “That puts pressure on prices.”

An overriding issue for the junk market, as for the stock market, is the pace of the economy’s recovery and whether it will be fast enough to lift many debt-laden companies out of the financial danger zone.

What’s more, the corporate bond market in general has been rocked by the financial scandals that have engulfed Enron Corp., Global Crossing Ltd., cable provider Adelphia Communications Corp. and long-distance giant WorldCom Inc., among others.

WorldCom, with $30 billion of debt, had its credit rating slashed again last week by Moody’s and by Standard & Poor’s. S&P; cut the company’s long-term debt rating from BB to B-plus, four levels below investment grade, citing the company’s financial woes.

The price of WorldCom’s 7.5% bonds maturing in 2011 has plunged from 94 cents on the dollar in early March to about 51 cents now.

“We’re just wondering where is the next Enron, the next Adelphia,” said Jon Budish, a high-yield bond trader at brokerage Jefferies & Co. in New Jersey. “Investors are very skittish. What’s happening behind the curtain at these companies? It’s hard to tell.”

Individual investors, who own about $90 billion in high-yield bonds through junk mutual funds, have turned decidedly negative on the sector. Junk funds took in about $13 billion in net new cash from October through April, according to fund tracker Lipper Inc. But investors, on balance, began to pull money out of junk funds in May, Lipper said.

Last week, investors pulled a net $504 million from junk funds, the biggest weekly outflow this year, according to estimates by AMG Data Services in Arcata, Calif.

But as junk yields near the highs reached in early October amid the financial sell-off sparked by the terrorist attacks, some analysts say investors brave enough to buy could pick up some long-term bargains.

“We said at the beginning of the month the high-yield market was overvalued. It got ahead of itself in anticipation of an economic recovery,” said Christopher Garman, high-yield bond strategist at Merrill Lynch & Co. “But we expect over the long haul for things to improve.”

One potentially positive sign is that the number of junk-rated companies that newly defaulted on their bonds (that is, stopped paying interest owed) dropped to 15 in May from 23 in April, Moody’s said. The dollar value of newly defaulted bonds declined to $15.5 billion in May from $19.5 billion in April, the firm said.

The annualized default rate on junk issues worldwide has been stuck at 10.3% of total bonds outstanding for three months, Moody’s said. The firm expects the rate to fall to about 8% by year’s end, assuming the economy continues to recover.

Analysts note that investors who bought junk bonds after the market slumped in 1990 earned stellar returns in 1991. The average junk bond mutual fund posted a total return (interest earned plus price appreciation) of 37.1% in 1991 as the economy recovered, interest rates fell and concerns about junk bond defaults subsided.

So far this year, some junk mutual funds still are posting positive, albeit small, total returns, as interest earnings barely offset share price losses. The Vanguard High-Yield Corporate fund is up 1.3% year to date, for example. The Merrill Lynch U.S. High Yield fund is up 2.7%.

But the Columbia High Yield fund is down 0.6%, and the Franklin AGE High Income fund is down 2.2%.

Jefferies’ Budish said timing is very important in the junk bond market, and that the market could be nearing a buying point.

But some market pros have been warning against investing in long-term bonds of all types. Bond guru Bill Gross at Pimco in Newport Beach advises investors to stick with shorter-term issues for the foreseeable future because he thinks the U.S. inflation rate could rise as the economy revives. That, in turn, could drive market interest rates higher, hurting the value of longer-term bonds, he said.

Gross said he is finding some bargains in beaten-down bonds of some telecom and energy companies that are still rated investment grade yet yield around 9%.

But that may provide unwelcome competition for the junk market: If investors can find substantial yields on issues that are investment grade, they may be less interested in taking on the added risk that comes with junk-rated securities.