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| Opportunities and Exposures: Finance |
Storm Warnings for Bond Investors
Martin Fridson
01/01/2005
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When first told that the high yield sector may be ripe for another downturn, investors who have put their faith in the conventional wisdom of financial advisors might be hesitant to believe that these booming bonds will again underperform.
Wall Street’s contingent of perma-bulls—those product specialists with a vested interest in discouraging investors from shifting their capital to other asset categories—argue that junk bond issuers and investors learned their lesson from the disastrous aftermath of the telecom bubble, which decimated the high yield bond market. They will claim that, in the wake of crashes by former highfliers such as Global Crossing and Iridium, people are loath to speculate in overly crowded industries with revenue models based mostly on optimism. We have heard those arguments before. The junk bond market financed the leveraged buyouts of the 1980s, and issuers supposedly learned their lessons when that house of cards collapsed.
 Today, high yield bond investors try to take comfort from the Federal Reserve’s easy credit policy, which is allowing many potentially troubled companies to stay in business. However, this, too, may end abruptly, ushering another bear market for high yield bonds.
Excessive corporate borrowing has fueled much of the high yield bond issuance in recent years, and this flood of product has spurred the sector’s sensational recovery since its nadir in October 2002. Speculative-grade debt produced a 28.15 percent total return in 2003, according to Merrill Lynch, easily outpacing stock market returns. High yield bonds’ absolute returns were lower in 2004, but they continued to outperform both stocks and top-quality bonds.
A major reason for the excellent relative returns over the past two years has been a drop in corporate failures. The trailing 12-month default rate reported by Moody’s Investors Service plunged from 8 percent at the end of 2002 to 2 percent in the third quarter of 2004.
However, an eventual rise in corporate defaults is all but certain. This is a natural feature of the business cycle, caused by a slowdown in the growth of GDP and a tightening of credit quality standards by lenders. This may not be long in coming; the high yield default rate customarily climbs- with a lag- after the credit quality of newly issued bonds deteriorates. This deterioration, too, is a standard feature of the cycle. It typically occurs when the painful memory of the latest default wave starts to fade.
Unfortunately, the deterioration in new issue quality has already begun. If investors learned their lesson with respect to the highly speculative telecom deals that brought them low three years ago, they do not seem to be applying it to other industries. According to Merrill Lynch, bonds rated CCC, the lowest-quality tier, represented 19 percent of new issue volume in the first three quarters of 2004. The comparable figures for 2002 and 2003 were 3 percent and 7 percent, respectively.
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