The Lure of Junk Bonds: Oasis or Mirage?
By Robert Rosenberg
With interest rates on savings accounts, money market accounts, and Treasury bonds at close to their recent lows after 13 consecutive rate cuts by the Federal Reserve, investors thirsty for yield are plowing into high-interest -- and high-risk -- junk bonds. In the week ended July 16, a record $1.22 billion poured into junk-bond funds, bringing year-to-date inflows to more than $23 billion.
Noninvestment grade bonds -- junk bonds -- are issues with credit ratings of BB and below that are issued by companies without long track records or sales and earnings or those with questionable credit strength. Because of the greater risk associated with such investments, companies must pay high interest rates to attract investors. But interest rates have been declining even in junk bonds. Consider: The spread, or difference between rates on junk bonds and Treasuries has fallen dramatically. And it has continued to narrow as more investors in search of higher yields have piled into junk bonds.
Are these high-risk issues a true oasis for yield-thirsty investors, or will they prove to be a disappointing mirage? George J. Konomos, co-portfolio manager at Mellon HBV Alternative Strategies, thinks the latter is more likely. "There's a complete disconnect between where these bonds are trading and the underlying fundamentals for these companies," he says. Konomos manages high-yield and distressed debt, and as signs that the junk market is frothy he points to the shrinking spreads, the spate of new issues, the numbers of triple-C credits trading at par and above, and companies already in bankruptcy whose credits are at 90 cents on the dollar.
First, says Konomos, "the double-Bs, the top of the tier, got bid up. Then it was the Bs, the Cs, and then the triple-Cs." The market, he believes, has gotten ahead of itself, and the end of story for many yield-searchers is likely to be a sad one.
The money entering the market has driven up the number of issues trading at par or above. Even "fallen angels" -- companies whose credit ratings have been downgraded -- are seeing their bond prices rise. And companies on ratings watch for possible downgrade also have bonds trading at par or above.
THEN VS. NOW.
What's more, issuers have been bringing out a spate of lower-quality bonds in response to the record inflows into junk funds, according to Standard & Poor's Global Fixed Income Research. Junk bonds yield about 500 basis points above the 10-year Treasury note, or around 9.3% (each 100 basis points equal one percentage point).
Merrill Lynch Chief North American Economist David Rosenberg agrees that little economic rationale supports the current strength of the junk-bond market. Rather, it's being driven by increased liquidity, with the accommodative actions of the Federal Reserve and investor's hunger for yield. "The economy is still in what you might classify a 'stealth recession,'" he says. "If anyone is still positive after five months of negative nonfarm payrolls, maybe they're reading the charts upside down."
On the other hand, Merrill Lynch analyst M. Christopher Garman says the junk-bond rally is a reflection of just how undervalued the high-yield market was in October, 2002, when the spread between junk bonds and Treasuries was 1,000 basis points. Garman says in many ways, current conditions remind him of the 1991 rally, when the economy was also emerging from recession and spreads tightened. Back then, the junk-bond rally turned out to be an early indicator of an economic rebound, and strong growth resumed.
TOO MUCH CAPACITY?
Some important differences exist between now and 1991, Garman acknowledges. In 1991, the economy was coming off higher levels of inflation associated with wider spreads and entering a period of lower inflation, which gave issuers an opportunity to refinance -- a major source of spread compression.
Another key difference: capacity utilization, an important indicator in the model that Garman uses to figure out whether the high-yield market is overvalued or undervalued. According to his model, at current spreads, investors appear to be anticipating 79% capacity utilization in the manufacturing sector. Right now, it's below 75%.
Another difference is default rates. Even though they're down now for junk bonds, says Garman: "This is actually the slowest rate of deceleration [for defaults] on record, even going back to the Great Depression." Some experts argue that the Fed's easy-money stance has made it possible for companies to clean up their balance sheets and lower heavy debt burdens, making the possibility of default less great.
Despite such rhetoric, that hasn't happened to the extent anticipated, says Gregory Peters, a Morgan Stanley high-yield analyst. "In their bid for yield, investors have pushed the envelope of value," says Peters. In order to keep up with others in their peer group, portfolio managers of junk-bond funds are stooping to buy ever more risky issues.
Still, even though junk was undervalued prior to this recent rally, high-yield investors are pricing in a much stronger recovery and economic conditions than are apparent at this time, Garman says.
Sure, Alan Greenspan & Co. could be right, and the economy is ready to head into strong growth. If that's the case, the junk-bond market's performance is simply a portent of a powerful recovery as it was in 1991 -- and yield investors will end up happy. But given the mixed results of recent economic indicators, those questing for yield may be taking a bit too much for granted.
Rosenberg follows the markets from New York City
Edited by Patricia O'Connell