Junk Bonds Are on a Roll, But Danger Lies Ahead

The junk-bond market is closing out its best month in years, but many investors and analysts are skeptical about the outlook. The concern in the junk, or "high yield," market isn't just a likely surge in defaults, which is the norm for companies with low credit quality during an economic downturn. This time around, there are worries that when defaults occur, the recovery rates on those bonds and loans will be far more meager than in the past. The main source of those concerns is the hundreds of billions of dollars of noninvestment-grade loans issued in recent years. Before the onset of the credit crunch, such loans went to market with fewer protections for holders in the event that issuers ran into financial trouble. In order to compensate investors for the increased risks of holding that debt, some say yields will need to stay relatively high and that prices may not improve much. Still, investors in the high-yield debt market can smile for now. The Merrill Lynch High-Yield Bond Index is up 0.6% for the year, having been down 4.5% on March 17, the day after the collapse of Bear Stearns Cos. The yield spread over comparable U.S. Treasurys, a barometer of market sentiment, has narrowed sharply to 6.85 percentage points from a high of 8.6 percentage points. Yet, with an average yield of about 10%, high-yield debt offers a healthy income stream. Investment-grade corporate bonds are yielding around 6%. Like other parts of the bond market, sentiment rebounded after the Federal Reserve aided J.P. Morgan Chase & Co.'s pending takeover of Bear Stearns in an attempt to keep the brokerage house's problems from spiraling through the financial system. That, combined with the Fed's decision to let brokerage houses borrow from the central bank, created a greater comfort with taking on risk. Meanwhile, brokerage houses have made progress in clearing the decks of hundreds of billions of dollars of high-yield debt that had been sitting on their books since last summer, particularly loans backing leveraged buyouts. Now the focus is on the economy and credit quality of low-rated issuers. "This is the most dangerous time of the cycle for high yield," says Tom Swaney, a portfolio manager and head of the credit team at OppenheimerFunds. "You know the defaults are going to come, but you don't know exactly when, and you don't know what kind of risk premium you need to earn to ride it out." Thus far, default rates, which have risen, remain low. Still, Moody's Investors Service last month said it expects defaults on U.S. speculative-grade debt to rise to 6.6% by next March from 2.2% last month. If the economy goes into a deep recession, defaults could top 10%, Moody's says. However, Moody's believes that, thanks to healthy corporate balance sheets outside the financial sector, a more likely outcome is that fewer defaults will materialize. While high-yield investors are used to the ups and downs of the default cycle, there is a new wrinkle to contend with. Starting in 2004, many low-quality companies that would have issued conventional, unsecured high-yield debt instead turned to the syndicated-loan market, especially for leveraged buyouts.