Trashed junk bonds making a comeback
Investors in corporate junk bonds have recouped about half of their losses from the summer credit crunch.
But some analysts warn that the plunge in high-risk bond prices in June, July and August could be a dress rehearsal for what the popular securities might face next year if the economy weakens substantially and more companies have trouble paying their debts.
Defaults on junk bonds have been at two-decade lows, but virtually no one on Wall Street believes that can continue.
“Default rates have to escalate sooner or later,” said Martin Fridson, head of junk-bond research firm FridsonVision in New York.
The $1-trillion junk market -- bonds of companies rated below investment grade in quality -- had been a key element of Wall Street’s easy-money environment of the last few years. Investors, hungry for high yields, were eager buyers of the debt.
But the easy money dried up in midsummer. Rising defaults on dicey mortgages spooked investors in other high-risk securities, including junk bonds, and triggered across-the-board selling that drove prices down and yields up.
The annualized yield on an index of 100 junk issues tracked by KDP Investment Advisors rocketed from 7.08% in mid-May to 8.85% in late July, a four-year high.
In recent weeks, however, cash has come back to junk bonds and other high-risk securities, thanks in part to the Federal Reserve’s half-point cut in short-term interest rates on Sept. 18. The Fed was trying to ease the money crunch that developed as nervous banks and investors pulled back from extending credit.
The yield on the KDP index was at 7.87% on Thursday, the lowest since July 9.
“The market is a bit calmer now,” said Edward Altman, professor of finance at New York University and a leading academic expert on junk bonds.
Many junk bond mutual funds have regained about half of their summer declines as the securities’ prices have revived.
The share price of the $9-billion Vanguard High-Yield Corporate fund, for example, sank from $6.31 on May 22 to $5.82 on July 27, a drop of 7.8%. It has rebounded since, to $6.07 on Thursday.
But year to date, junk fund investors haven’t earned much. The average fund’s total return -- interest earnings minus principal loss -- is 2.8%, according to Morningstar Inc. In 2006, the average fund’s return was 10.1%.
Now, two big tests loom for the junk market.
In the near term, more than $200 billion of corporate buyouts announced in the spring have to be financed. The deals typically use money raised via junk securities and bank loans to pay off shareholders.
Despite the pullback in junk yields -- which should be good news for buyout firms -- few new junk bonds have come to market this month. Just eight issues worth a total of $3.7 billion have been sold in September, compared with 40 bond issues worth $22.5 billion in June, according to Thomson Financial.
Some buyout firms are walking away from deals. On Wednesday, an investor group that had planned to buy student loan company Sallie Mae for $25 billion said the deal terms were no longer acceptable, although it left the door open to renegotiate.
Kingman Penniman, head of KDP in Montpelier, Vt., said he remained concerned about the potential for a glut of junk issues to hit the market soon, which could force yields up if investors demand higher returns to absorb the supply.
“The market still has the ability to destroy itself if [companies] try to stuff in too many of these deals,” Penniman said.
Longer term, the question is how many junk-rated companies will run into trouble paying their debts.
A rise in defaults can have two effects. Investors who own the affected securities can face hefty losses, and investors generally may become more reluctant to buy junk issues, pushing interest rates up and devaluing older bonds.
Bond defaults have been relative rarities in the last few years as the economy has grown and companies have had easy access to credit.
Altman, the professor, said just 0.76% of the dollar value of outstanding junk issues went into default in 2006, a two-decade low. That rate fell further, to 0.26%, in the second quarter of this year.
As recently as 2002, at the tail end of the bust in the telecom and technology sectors, the default rate reached a record high of 12.8% of outstanding junk debt.
The KDP bond index yield soared to 12.3% in 2002 as spooked investors fled.
The consensus among junk bond experts is that defaults will rise in 2008, in part because of the slowdown in the U.S. economy. But many analysts simply expect a return to typical default rates, which Altman said would mean about 4% for the full year.
That assumes, however, that the economy doesn’t fall into a deep recession, he said.
Credit-rating firm Moody’s Investors Service predicts a junk default rate of about 4.5% over the next 12 months.
Some junk-bond mutual fund managers say they don’t foresee a return to 2002 default levels soon because many junk-issuing companies took advantage of easy credit in recent years to stretch out their obligations.
Others say the junk sector comprises a more diversified group than in 2002, when tech, media and telecom firms made up a large chunk of the market. General Motors Corp. and hospital giant HCA Inc. are in the junk sector now, for example.
“I think there is a better, more proven cohort of companies in the market” than five years ago, said Paul Scanlon, manager of the Putnam High Yield fund.
Many junk investors gauge the appeal of the bonds based on their yield advantage over high-quality bonds. At 7.87% now, the KDP index yield is 3.3 percentage points above the 4.57% yield on 10-year U.S. Treasury notes.
That is a sharp improvement from early June, when the difference was just 2.16 points. But in late July, the difference widened to 4.09 points.
For investors’ sake, “I wasn’t happy to see the yield fall below 8%,” Penniman said.
Fridson, of FridsonVision, questions whether investors are being paid enough relative to the risk that the economy -- and junk defaults -- could be worse than expected next year.
His advice to potential junk investors: “I would say hold off. I think you might have an opportunity to buy this stuff cheaper.”
