Waiting For Junk To Tumble

It could happen soon, given a torrent of new debt and a possible interest-rate hike

Is the junk-bond market a bubble waiting to burst? The ride has been exciting -- and profitable -- for investors who poured $27 billion into high-yield-bond funds last year, more than twice as much as in 2002. The average fund had total returns of 24% last year, nearly five times what the typical U.S. taxable-bond fund made, according to fund researcher Morningstar Inc. The out-of-the-park performance is continuing this year: Junk bonds delivered 3% gains in the first three weeks of January, triple the gains on the Lehman Brothers (LEH ) Aggregate Bond Index.

But there are plenty of warning signs. The huge demand for junk has enabled companies with poor credit ratings to issue a torrent of new debt -- sometimes for questionable purposes -- while paying less interest than before. At the start of 2003, junk bonds yielded an average of eight percentage points more than 10-year Treasury bonds. By the end of the year, the spread had been cut in half, to just four percentage points. Considering the risks investors are taking, says Lawrence Schloss, head of private-equity investing at Credit Suisse First Boston (CSF ), they're no longer getting rewarded enough. "That's a future accident waiting to happen," he adds.

DEFAULTS ON THE RISE? The obvious danger is that an interest-rate rise could pummel the market. A hike in rates would probably send bond prices plummeting while adding only a few points to yield. The avalanche of new bonds is also a cause for concern. Last year, Wall Street issued a record $125 billion worth of junk bonds for borrowers, according to market tracker Thomson Financial (TOC ). That's more than twice the level of 2002. Those billions are worrisome because spikes in junk-bond issuance are typically followed by periods of high defaults, according to research by bond-rating firm Standard & Poor's. That happened in 1990-91 and again in 2001-02, when bankruptcies soared. "Probably starting in the middle of 2005, defaults will start picking up," says John Bilardello, global head of corporate ratings at S&P.

Already, symptoms of a frothy market are present. Buyout firm Thomas H. Lee Partners acquired mattress-maker Simmons Co. late last year. The company now has more than six times as much debt as cash flow available to service it. That's high by historical standards. Junk bonds also are being used to take money out of a business rather than put it in. Investment firms Blackstone Group, Apollo Management, and Goldman Sachs (GS ) bought water-treatment outfit Ondeo Nalco Co. in November for $4.2 billion, loading it up with junk debt. In January, the three firms piled on more debt, selling another $450 million in bonds to finance a dividend for themselves. That prompted S&P to downgrade the debt issued just two months earlier. Blackstone says it paid the dividend to reduce the risk of the deal. "We felt the value of the investment had already appreciated," says Hamilton E. James, vice-chairman of Blackstone. "We still own the company, but with less money at risk."

A ONCE-IN-A-DECADE RALLY. Fund managers aren't panicking and cashing in their chips just yet. Peter Ehret, co-manager of the $1.5 billion AIM High Yield Fund, argues that there are fundamental reasons why junk bonds are performing well and could continue to do so. Two-thirds of the new issues last year were used to refinance existing debt at lower rates, a boost to the borrower's financial health. As the economy expands, many borrowers should see better profits and ratings upgrades. "We're not willing to declare the market in rampant excess just yet," Ehret says.

Still, some junk-bond pros -- the folks at AIM included -- are taking steps to insulate their portfolios from a possible downdraft. They're investing in higher-quality junk and in shorter-term securities that will get clobbered less than longer-term bonds if interest rates rise. "This was a once-in-a-decade rally," says Raymond G. Kennedy, who oversees $17 billion in junk bonds at giant Pacific Investment Management Co. in Newport Beach, Calif. Kennedy figures that junk investors won't see much price appreciation this year, but they won't lose much of their principal, either. He's forecasting a return of 6%-8%, about what the bonds pay in interest.

But if history is any guide, defaults will rise and the skyrocketing high-yield market will fall back to earth. That's why they call it junk.

By Christopher Palmeri in Los Angeles and Emily Thornton in New York

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