`Junk' bonds seem to defy their nickname - and gravity
High-yield bonds, those controversial darlings of corporate takeover artists, have weathered the bond market's bear market far better than their corporate and government bond siblings. United States Treasury bonds, catching a scent of rising interest rates and inflation, are seeing their yields go up and prices fall. The dynamic duo of rising interest rates worldwide and a large supply of state and federal bonds awaiting auction packed a punch that last week sent bond yields to their highest level in almost two years, to 9.85 percent.
The rising interest rates, however, did not affect the Dow Jones industrial average, as it closed the week up 70.82 points, at 2640.99, reversing its slide.
The rising interest rates also did not touch the high-yield bonds, which are also called ``junk bonds'' because they lack investment-grade ratings and therefore carry higher interest rates, and are considered more risky.
``The impact of rising interest rates is not as great on the high-yield bonds as on Treasury bonds; high-yield bonds are not as reactionary,'' says Joel Isaacson, manager of personal financial planning at Weber, Lipshie & Co., in New York.
It is not surprising that junk bonds have not had the same experience as Treasury and corporate bonds, observes Bob Fishman, vice-president of investments at Oppenheimer & Co., New York.
``As companies have gotten stronger by selling off units or whatever else they do to reduce debt, the security behind the bond has gotten stronger,'' Mr. Fishman says. ``The bottom line in corporate America over the past few years has been restructuring, and companies have taken on a lot of debt to do that.''
Yields on 30-year Treasury issues from the end of this March to the end of September increased from 7.8 percent to 9.74 percent. The spread between the yields of Treasury bonds and junk bonds increased from August to September, reflecting higher interest rates.
``On the whole, over the past couple of years, I'd say that junk-bond yields have stayed the same,'' Fishman says. ``It really, however, depends on the company behind the bond.''
The company is the key to a junk bond's performance. Fishman offers the example of what happened to the high-yield bonds financing the takeover of Beatrice Foods. Kohlberg Kravis Roberts & Co. took the company private in April 1986, formed a holding company, and started paying down the debt.
Beatrice issued high-yield bonds with 12.75 percent interest rate at par, which means they would pay $1 for every $1 invested when redeemed in April 2001. For the sake of comparison, in April 1986 a 30-year Treasury bond closed the month at 7.46 percent.
``Today the Beatrice bonds are trading at $1.05, so the yield has come down. For every $10,000 you'd invested, you'd get back $10,500,'' Fishman explains. ``This shows how much stronger the company has gotten through the restructuring.''
Not all junk bonds perform so well. ``If you want to invest in junk bonds, read the prospectus,'' Fishman advises. ``There might be special provisions or special calls. You don't have to worry about those kinds of things with Treasury bonds.''
Junk bonds are investors' friends or foes, because of the job they help do. While some high-yield bond funding goes into strengthening or growing companies and leveraged buyouts, some of it has fueled hostile takeovers.
In the last couple of weeks, seven junk-bond offerings have reached the market. Since the beginning of the year, 188 offerings totaling $24.4 billion have been issued. For the same time last year, 162 offerings worth $23.7 billion came out, according to Tim Harlin, a vice-president at New York-based IDD Information Services, which tracks new issues.
``The numbers have been pretty huge,'' says Steve Anreder, a senior vice-president at Drexel Burnham Lambert Inc., New York. Mr. Harlin says Drexel is the leader in offerings last year and this year. Drexel is considered the architect of junk-bond financing. ``The impressive thing about these offerings is that the market has been able to absorb all these deals, even in a rising interest rate environment,'' Mr. Anreder adds.
Yet, some people have doubts about junk bonds. Mr. Isaacson of Weber Lipshie says the economy's condition encourages investors to redeem bonds rather than buy them. ``This may be the time to switch out of high-yield funds into money market funds and just sit out this interest rate environment,'' Isaacson says. He thinks the possibility of default on junk bonds is great.
``Although people say there has been no default in junk bonds, there is so much new junk bond activity that one default could really hurt the market,'' he says. ``We haven't seen them through a recession. How will the companies with little equity and heavy debt survive? I'm not a major advocate of junk bonds.''