The high-yield bond market has been on a tear since late 2002. CCC-rated issues dropped from a high yield of 25.7% in September 2003--at a time when ten-year Treasuries were a low 3.59%--to 12.22% at year-end 2003. Single B-rated issues likewise dropped, from 13.5% to 7.6%.
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This phenomenal change in perception was no doubt stimulated primarily by the end of the 2000-2002 default cycle, which saw a virtual meltdown of high-yield credits. The prevailing logic was that with a growing economy and a cleanout of shaky companies, the surviving issuers were good for some time to come.
History would bear out this opinion, but then times do change, and every meltdown has new wrinkles. The previous 1991-92 meltdown was recession-related but also had to contend with the collapse of
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Following the 1991-92 meltdown, high-yield bond issues took on a new character. Blind pool issues and those used to fund takeovers all but disappeared. New issues were mainly used to retire bank debt and other financial restructurings. The types of new issues changed again as the Internet/telecom boom took hold, setting the stage for the 2000-02 default wave, but there were at least five years of "calm" before the defaults became prevalent.
Coming out of this most recent meltdown, I see signs that the groundwork is being laid for the next disaster. This is mainly due to the fact that yields in the investment-grade market are now so abysmal that only by taking on more risk can fixed-income investors receive the kind of returns they have gotten used to. What most of these "fixed-income" investors fail to recognize is that high-yield bond investing is more analogous to total return stock investing than to bond investing. Hence, in the high rate environment of the past, gains from rate declines contributed as much to total return as actual interest payments.
In the current single-digit junk bond yield environment, where there is little or no default risk premium embedded in the yields, the capital gain aspect of total return has evaporated. In fact, it is more likely that there will be a capital loss. Worse yet, with the low coupons on new issues, the prospects for capital gains are dim. Investors who think they can make money in this kind of a market already have more tax loss carryforward than they will ever need.
And, as if the single-digit yields weren't bad enough, new-issue high-yield bonds show significant quality deterioration in the form of covenant protection. While every bond indenture is different, certain standards are generally observed. Former
Also, use-of-proceeds risks arise when issuers are free to use the bond proceeds to pay shareholders large special dividends now subject to only a 15% tax rate. Great for the stock investors--they cash out a part of their holdings without trying to find buyers for often closely held, otherwise illiquid shares. Not so great for bondholders. So why do investors snap up these low-yielding instruments? Greed, and overconfidence that history can trump common sense. Hence, companies with serious problems such as
As a footnote, while high-yield bond rates have been plummeting, preferred yields have been a model of rate stability. While single-B bond rates sank from 13.5% to 7.6% between September 2002 and December 2003, B-rated preferreds went from 9.6% to 9.1%. If instead of junk bonds you had invested in these low-rated preferreds, you would have missed out on phenomenal capital gains. However it is my view that during a rate reversal, the risk of significant capital losses with these preferreds is much less. And in the meantime you can collect a yield premium of 150 basis points by buying these preferreds instead of straight high-yield bonds. Now there's a history lesson I can buy.
Excerpted from the February 2004 issue of Distressed Debt Securities by Richard Lehmann.
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