Junk Keeps Defying Gravity
For decades the junk-bond market has followed a pattern that's about as regular as spring following winter. Two to four years after a new wave of bonds hits the market, defaults on those bonds surge.
This time, the pattern isn't holding. Given the huge runup in junk debt that began in 2003, many investors figured defaults would spike last year and began raising hundreds of millions for new distressed-debt funds to take advantage of the wreckage.
But a funny thing happened on the way to the meltdown: According to Moody's Investors Service (MCO ), junk-bond defaults actually fell in 2006 for the fifth straight year, to 1.7%--well below the long-term average of 5%. The story is the same in the booming leveraged-loan market, which, thanks to more flexible borrowing terms, has become a favorite of the private equity firms raising billions for leveraged buyouts and the hedge funds that buy most of that debt. By the end of 2006, leveraged-loan defaults slid below 1%, an all-time low.
While many investors expect defaults to tick up this year, they've given up trying to call the turn. "They've simply been wrong too long," says Steven Miller, the managing director of Standard & Poor's (MHP ) LCD unit, which tracks the leveraged-loan market and is, like BusinessWeek, a unit of The McGraw-Hill Companies (MHP ).
Some private equity players see a major structural shift at play: Greater liquidity across the capital markets and the explosion of sophisticated financial instruments, they say, are reducing the level of risk permanently. But others say the cycle is just being delayed, possibly leading to a harsher crash when it turns. "The big question is whether the excess money is simply giving weak companies all the rope they need to hang themselves," says David T. Hamilton, Moody's head of credit default research.
To see why some are worried, consider the record amounts of risky debt that have flooded the market in recent years. Start with junk bonds: New issuance has soared from $62 billion in 2002 to an average of $127 billion annually over the last four years. And that market has been dwarfed by the rise of leveraged loans, the higher-yielding bank loans that hedge funds and other investors are snapping up. Since 2002, the issuance of leveraged loans has more than tripled, to $480 billion last year, according to LCD.
It's not just the quantity of loans that's worrisome--it's also the quality. Much of the debt is rated B or Caa and below, the bottom rungs of the credit ratings ladder. Since 2004, roughly one-third of all leveraged loans issued each year have been rated B or lower, compared with less than 11% on average the previous four years. For junk bonds, the figure tops 50%. In 2006 alone, some $200 billion in low-rated debt hit the market, a surge William H. Chew, a managing director at Standard & Poor's, calls "unprecedented."
Those are just the bonds that tend to go belly-up. Between 1970 and 2005, one-third of all B-rated bonds defaulted within 10 years, according to Moody's; for Caa and below, the figure is 44%. Many defaults come sooner than that. In pioneering research done in the late 1980s, Edward I. Altman, a New York University finance professor, showed that junk-bond defaults are concentrated early on, with the peak coming three to four years after issuance. Credit market analysts refer to this phenomenon as "seasoning," the time it typically takes a risky company with new financing either to make a go of it or to go bust. Since 1970, 36% of bonds rated Caa or less have defaulted within just three years, as have 17% of B-rated bonds.
But for now, that isn't happening, and the surge in LBO-fueled debt is likely to continue in 2007 as well. Interest rates remain astonishingly low. In 2003 junk-rated debt typically sold for 5 to 8 percentage points above the yield of the 10-year Treasury bond; that spread has since dropped to 3.4 points. "More and more people are buying very speculative debt, at pricing that just doesn't justify the risk," says Chew.
All of which leads to an obvious question: Why haven't defaults begun to kick up? Analysts cite a host of reasons, starting with the relatively strong economy and the recent muscle in profits. But the biggest factors are the enormous amount of money sloshing around and the changing structure of the debt market. Foreign investors are shipping gobs of cash into the U.S. At the same time, there has been an explosion of hedge funds, distressed debt traders, and others eager to buy junk-rated debt for the higher yields it offers, much of it chopped up and resold in other sophisticated financial instruments such as collateralized loan obligations. Together, these factors have combined to create unheard-of pools of liquidity. Not only has that helped keep a lid on interest rates--holding debt payments down--it has also made funding readily available even for struggling companies.
There's another reason, too: easy borrowing terms. Restrictions and stipulations based on the financial health of the debtor are practically nonexistent these days, in both exotic leveraged loans and ordinary corporate bonds. Historically, when borrowers have violated such basic rules, they've been forced into default. Now, says Martin S. Fridson, a high-yield bond market strategist who runs the New York-based firm FridsonVision, the restrictions "have been so watered down, there's nothing left to trip."
Fridson, like Altman, believes the pain is simply being put off and defaults will return to historic patterns. Both predict a small climb this year and a sharper rise in 2008. And they say the level and severity of defaults may be worse when they finally hit, precisely because weak players are continuing to pile on new debt. Altman believes defaults could eventually approach the 10% rates seen in the early 1990s, in the wake of the last LBO boom. "If companies can keep getting money, they will," says Fridson. "But a lot of it is going to keep companies alive that really should not be."
By Jane Sasseen