Waiting for Junk Bonds to Bounce Back

Junk bond owners’ only consolation about 2005 is that things could have been worse.

Investors in the average corporate junk bond mutual fund last year earned a total return of 2.5%, which was interest income minus principal loss, according to Morningstar Inc.

That doesn’t sound like a “high yield” investment -- and a high yield, of course, is the whole point of owning junk bonds, those relatively speculative company IOUs that have become popular with many individual investors over the last 15 years.

The question now is whether the junk sector is headed for a rebound this year or whether it has begun a period similar to 1998 to 2002, when buy-and-hold investors in the securities actually lost money over five years.

A nagging concern is that, with the steep decline in most interest rates worldwide since 2002, investors simply aren’t being paid enough for the risk they’re taking in junk issues or even in higher-quality bonds.

Junk bond optimists, however, expect the sector to get back to doing what it’s supposed to do, which is to provide investors with a return significantly better than what they could earn on Treasury bonds or other investment-grade securities.

Junk bonds are all of those considered below investment grade, and there are lots of them -- $840 billion outstanding in the U.S., from companies as disparate as Chiquita Brands International Inc., J.C. Penney Co. and Royal Caribbean Cruises Ltd.

The bullish case for junk is that the economy is healthy and will continue to grow fast enough so that few junk-issuing companies will have trouble making their debt payments. This case also assumes that market interest rates won’t rise significantly from current levels.

A leveling off of interest rates in a strong economy could allow junk investors to collect decent yields without worrying about principal loss.

But to perform well for investors, the junk market also must avoid the kind of big scare that hit it in 2005.

Fear that General Motors Corp. would file for bankruptcy protection helped trigger a sharp run-up in junk bond yields last spring, as investors began to question whether a host of debt-heavy companies might end up defaulting on their bonds.

GM still is solvent, but the junk market never fully got over the fright. The average yield on an index of 100 junk issues tracked by KDP Investment Advisors rocketed from 6.5% in February to 8.1% by mid-May. It fell back to 7% in summer, then rose again in fall and now sits at about 7.6%.

And that’s what clipped junk bond mutual fund returns in 2005. As market interest rates rise, the value of older, lower-yielding bonds declines. So even though junk fund owners may have earned interest income equivalent to a yield of 6% or more for the year, the principal loss they suffered on their fund shares left them with a total return of just 2.5% on average.

By contrast, when the junk bond market is healthy, the annual total returns can easily be in the double digits. That was the case in 2004, when the average junk fund gained 10%, according to Morningstar.

The glass-is-half-full view of the market is that the economy, and junk bonds, fared well in 2005 considering soaring energy prices, the Federal Reserve’s credit-tightening campaign and GM’s woes. The GM scare was one of perception over reality: The actual junk default rate fell to an eight-year low of 2.2% of U.S. issuers last year from 2.8% in 2004, according to credit-rating firm Moody’s Investors Service.

There were, however, some high-profile junk defaults as some very large companies skidded into bankruptcy, including Delta Air Lines Inc. and power company Calpine Corp.

Junk bond bulls insist that it’s highly unlikely the market will face a surge in defaults this year.

“The default rate will tick up, but we don’t see a systemic increase,” said Michael Roberge, chief fixed income officer at mutual fund firm MFS Investment Management in Boston.

His optimism, he says, is rooted in the fact that money still is relatively easy. It’s when the corporate financing window slams shut that the junk market reels. “We are nowhere near a period when credit is not going to be available to companies,” Roberge said.

A credit crunch is what launched the junk sector’s miserable stretch of 1998 to 2002. When hedge fund Long-Term Capital Management nearly failed in September 1998, it caused credit to dry up across the corporate finance market. That credit crisis deepened for many marginal companies in 1999 and 2000 as the Fed raised short-term interest rates.

Then the recession arrived in 2001. By early 2002, more than 11% of U.S. junk-issuing companies had been in arrears on debt payments in the previous 12 months, according to Moody’s. That default wave pushed the yield on the KDP junk bond index above 12% in 2001 and 2002 as investors demanded sharply higher rates to compensate for the risks they faced.

As it turned out, 2002 was a great time to begin buying junk securities. The recession ended, defaults began to decline and interest rates were sliding.

Still, in the five years through 2002, the bitter reality for average junk bond fund owners was a net loss of 1.5% a year. They would have been better off in the bank.

The problem today, some bond pros say, is that even though junk yields are up from a year ago, they aren’t enough to compensate for the trouble that may loom down the road for many junk-issuing companies -- maybe not in 2006, but in 2007 or 2008.

“We don’t see much value in the corporate market,” said Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles.

It’s true that there isn’t a credit crunch, he says, but that just is allowing some junk companies to take on debt with impunity.

“The quality of the underwriting in high yield is as bad as we’ve seen in years,” Rivelle said.

What’s more, bond investors increasingly are feeling like steerage passengers compared with equity investors. Many companies are buying back record amounts of stock to please shareholders (including hedge fund activists) who are clamoring for higher share prices.

If a company boosts its debt level to finance a buyback, its bondholders may suffer if the market’s perception of the firm is that it’s becoming more highly leveraged and therefore more vulnerable to financial trouble in the next recession.

To say the least, all of this is making it much more important to be careful in choosing individual bonds, fund managers say.

“You want to avoid situations where management teams are moving from rewarding bondholders to rewarding shareholders,” said Gibson Smith, manager of the Janus High-Yield bond fund in Denver.

He says he is reasonably upbeat about the economy this year and is expecting to be ready to pick up bargains in some of the most troubled sectors of the junk market, including the auto sector.

“I think some tremendous opportunities are going to emerge in that sector in 2006,” Smith said.

At the same time, he says, he’s avoiding the retail and media sectors, in which he sees the greatest risk of companies piling on more debt because of industry consolidation and pressure from activist shareholders.

In a low-interest-rate world where investors are settling for 4.4% on 10-year Treasury notes, junk bond yields of 7.6% may well be attractive enough at the moment, Smith says.

But he also concedes that he’s in an inherently cyclical business. If the economy and corporate earnings slow, debt levels that appeared reasonable in boom years could suddenly become onerous. The rising challenge for junk bond fund managers, Smith says, will be in sifting the risks worth taking from the true junk.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit www.latimes.com/petruno.