Junk Bond Investors See Red as Defaults and Downgrades Rise
Corporate junk bond mutual funds, the most popular long-term bond fund category of the 1990s, suddenly are seeing many individual investors flee.
And no wonder. Default rates on junk bonds--interest-bearing IOUs issued by companies considered less than investment-grade in quality--already are near recession levels.
What’s more, rating agency downgrades of junk issues are outnumbering upgrades by a wide margin, and “spreads” between junk bond and U.S. Treasury security yields are the widest since autumn 1998, when the Russian bond default sparked global panic.
Pretty gloomy, no?
On the contrary. Some prominent fund managers say that things may finally be looking up for the high-yield junk market.
“I know better than to say we’ve seen the worst, but I think we’re getting really close,” said Ben Trosky, manager of Pimco High-Yield fund in Newport Beach. “The high-yield market is starting to offer value for the first time in seven years.”
Although there certainly are risks, Trosky and other managers contend that junk yields of up to 6.5 percentage points over Treasury bond yields make some junk issues very attractive.
The Federal Reserve continues to push interest rates higher, which, paradoxically, may be good news for junk bonds, said Kathleen Gaffney, co-manager of Loomis Sayles High Yield fund in Boston.
The real danger for junk bond investors isn’t rising rates but the avalanche of defaults that could come with a severe recession. The Fed, however, insists it is just trying to slow the economy, not start a recession.
Even if the central bank miscalculates and hits the brakes harder than it should, Gaffney said, “The [yield] spreads are compensating you for much more [economic] weakness than we expect.”
Many individual investors made a lot of money in junk bond funds in the 1990s. The funds produced a 10% average annual return in the decade, according to Morningstar Inc.
Junk funds now represent the largest category of long-term taxable bond funds, with 368 funds holding about $102 billion in assets, according to Lipper Inc.
The amount in junk funds far exceeds the sums in long-term government bond or high-quality corporate bond funds.
But the last few months have been a struggle for junk fund investors. Domestic junk bond funds had the worst first-quarter performance of any fixed-income fund class, with a negative average total return of 1.5%, Morningstar said.
Despite annualized yields in the 9.5% to 12% range, defaults, downgrades and slack demand eroded bond values to the point where the loss of principal more than wiped out interest earnings in the quarter.
Worried by some high-profile defaults and envious of the huge gains rung up by technology stocks, investors have yanked an estimated $4.5 billion out of junk bond funds so far this year, with more than $400 million coming out just last week.
The default rate of junk bonds outstanding was 5.4% in the 12 months ended March 1. Defaults haven’t been this numerous since 1992, the “hangover” from the 1990 recession.
Analysts blame the latest surge in defaults largely on lax underwriting standards in the mid-1990s that enabled some high-risk companies to get more attractive financing than was warranted.
Demand for junk bonds was so strong, and the economic climate so rosy, financiers let down their guard and brought some odoriferous deals to market, experts say.
In a stable economy, the risk of default begins to rise about three years after a junk bond issue is sold. Naturally, defaults can rise faster in a recession--or be forestalled in boom times if high-risk firms can continue to raise capital.
Some questionable mid-1990s deals are now coming home to roost. Perhaps the splashiest failure--certainly the biggest--was Iridium, which sank about $5 billion in junk bond financing and many millions of dollars more from a stock offering into an effort to develop a global phone service through a network of low-flying satellites.
But the ultra-expensive phones didn’t work indoors, customers stayed away in multitudes, and Iridium filed for Chapter 11 bankruptcy protection in August. The satellites were abandoned to go down in flames, a fate shared by junk bondholders, whose investment is now worthless.
If Iridium’s was a noble failure, the recent collapse in value of the debt of junk issuers Aurora Foods and Safety-Kleen Corp. could likely be described in harsher terms.
The top three executives of Aurora, San Francisco-based home of Duncan Hines and Aunt Jemima brands, resigned in February amid an accounting probe that could turn last year’s profit into a loss.
Safety-Kleen, a South Carolina trash hauler, on March 6 placed its three top executives on leave pending an investigation into “possible accounting irregularities.” The firm’s $2.2-billion worth of debt was trading at 15 cents on the dollar last week, analysts said.
Analysts are worried about a growing list of junk issuers. The quarter just ended was the worst in years in terms of the ratio of junkbond rating upgrades to downgrades by Moody’s and other agencies. Seventy-two issues, with a face value of $29.7 billion, were downgraded in quality, while just 15 issues, totaling $9.3 billion, received upgrades.
John Lonski, economist at Moody’s in New York, said the downgrades could be a leading indicator of another uptick in defaults.
But Gaffney of Loomis Sayles disagrees. “I don’t think it goes much farther,” she said, adding, “The market is pricing in a recession, which I think is a very low risk.”
Analyst Todd Prono of Chase Securities predicted in a recent report that the junk bond default rate would ease to around 3% by the end of this year.
Pimco’s Trosky said that with yield spreads as wide as they are between junk bonds and high-quality bonds, investors can withstand a fairly high level of defaults and still get decent returns in a diversified portfolio.
Still, if recession is in fact looming, junk issues could suffer badly if investors bail out of the bonds. In the recession year of 1990, as defaults soared, the average total return on junk bond funds was a negative 11%.
Trosky suggested that investors look closely at what their funds own. Higher-quality junk issues--those with “double-B” ratings instead of “single-B” ratings--could hold up better if the market tanks.
Junk bond investors also must keep an eye on the stock market.
Although a period of leaner stock-market gains could make junk bonds more attractive for risk-oriented investors, a real crash in stocks would also hurt the high-yield market.
How? A crash could shut down the market for new stock offerings and make it harder for some cash-strapped firms to raise capital to make their junk bond interest and principal payments.
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Times staff writer Thomas S. Mulligan can be reached by e-mail at thomas.mulligan@latimes.com
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More Junk Goes Bad
The default rate on high-yield corporate junk bonds that is, the percentage of bonds that have stopped paying interest owed to investorshas surged during the last year to the highest level since the early 1990s. The annualized default rates for the junk bond universe each year, and for the 12 months ended March 1 of this year:
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Latest 12-month default rate: 5.4%
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Source: Moody’s Investors Service
Yields Resurge
Average yield on 100 junk bond issues tracked by KDP Investment Advisors, year-end figures and latest:
Friday: 11.02%
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Source: Bloomberg News
