Assessing a jump in junk bond defaults
No one denies that junk bonds are risky. But quality is sliding, red ink rising, and ``riskless'' Treasury bonds have actually produced a better total return over the past year. ``The number of defaults has skyrocketed,'' says Gail Hessel, senior vice-president at Standard & Poor's, the credit rating service. Through mid-September, defaults this year reached a record $3.1 billion -- nearly three times the 1985 level, according to S&P.
Ms. Hessel pins the abrupt rise on three things:
Demand for (and supply of) junk bonds is soaring like a Gary Carter homer. About $30 billion in new issues have come out so far this year -- more than twice last year's total. The fastest growth within the junk bond segment is in the lower-grade, speculative debt. As interest rates fall, more investors flock to the high-yielding securities. And companies are obliging with more supply.
``It's astounding what some of these companies can sell to the public,'' says Hessel. ``The market would have laughed at these offerings a few years ago.''
The bulk of defaults have come in oil, steel, and some airline issuers. Ongoing economic sluggishness, lower commodity prices, and heightened competition are blamed.
Changes in bankruptcy laws have allowed solvent companies to seek bankruptcy protection from creditors.
At present, the overall default rate for junk bonds hangs at a lofty 3 percent. That compares with an average of 1.5 percent from 1974 through 1984, according to Edward I. Altman, a New York University finance professor and consultant.
But Drexel Burnham Lambert, the premier junk bond dealer, with about 45 to 50 percent of the market, is not impressed. ``I don't think the default numbers are all that significant,'' counters chief executive officer Frederick H. Joseph. ``Take LTV out and you've got a whole different animal.''
Indeed, the bankruptcy of LTV Corporation last summer accounts for $1.6 billion, or nearly half the total default sum.
Still, Hessel says, ``I would expect the default rate to continue to rise. Not only this year but on into the future. We haven't seen the end of the bust in oil and steel. Beyond that, there are some very risky credits being sold.''
But Dr. Altman at NYU isn't particularly worried. ``Yes, the default rate is quite high. But it's not as much cause for concern as some people are saying.'' He points out that the default rate hit 3.15 percent in 1982 and 4.5 percent in 1977. ``Junk bonds still offer a pretty good risk/return trade-off if you diversify.''
Martin S. Fridson, manager of credit research at Morgan Stanley & Co., concurs. ``A fairly high default rate, during a recovery, simply emphasizes how balkanized the economy is today. Cash flow continues to be strong in most firms. The default rate hasn't had a measurable effect on the market.''
Mr. Fridson shows why he believes investors are unperturbed. ``Suppose you have $25,000 in a high-yield mutual fund with a 12 percent yield. When LTV defaulted, that was 1.5 percent of the market -- the largest default ever.
``So the fund sells out the position -- gets 30 cents on the dollar. Reinvests at 12 percent. For that 1.5 percent of the fund affected, he's lost 70 cents on the dollar, or a total loss of about 1 percent of the fund. The guy was getting a check for $250 a month. The default cost him $2.50 out of the $250. Is this guy really going to bail out?''
Insurance companies are major junk bond buyers, but they're not likely to vacate the market, either, Fridson says. ``They've got a lot of pressure to offer competitive rates. To maintain the yields on their portfolios, they have to downgrade in [bond] quality.''
But state insurance regulators may try to limit junk bond use, James Grant, of Grant's Interest Rate Observer, notes in his Oct. 20 issue. The New York Insurance Department found some insurance firms with up to 42 percent of their assets in low-grade bonds. Mr. Grant says the department is leaning toward a 20 percent cap. ``A thrust towards junk bond restrictions in the Empire State may make big market waves.''
It is true that ``no default'' Treasury bonds on average have offered a better return (about 3.5 percent higher) this year than risky junk bond funds. As interest rates have tumbled, prices of the more rate-sensitive Treasury bonds have shot up. Junk bonds, meanwhile, have not seen such price appreciation.
``Junk bond haters always seize upon these short-term periods when rates drop, and say `Ah-ha!' '' says Fridson. ``But is the typical bond buyer looking for total return or income?''
Junk bonds are yielding 12 to 13 percent on average, well over the 7.5 percent yield on Treasury bonds. ``If you compound that 400 to 500 basis-point [4 to 5 percent] advantage, it's virtually impossible for Treasuries to outperform high-yield bonds over a five-year period. The only scenario where that won't happen is when defaults are so bad that we're in a depression,'' he says.
Still, some worry the economy is walking a tightrope. If it slips, the trend of corporations, banks, and insurance companies relying on increasingly speculative debt may lead to a bond market collapse. ``It is the nature of markets to test the extremes of an idea,'' James Grant said recently. ``It seems to me the credit markets are currently pushing the extremes of leverage.''