Corporate bonds market is reeling too

It isn't just the stock market that is reeling. Corporate bonds, which many investors often considered safer than stocks, have had their biggest declines ever in recent weeks. Returns in the $745 billion junk-bond market, debt of companies with weak balance sheets and cash flows, are down more than 17% in the past five weeks, and 19% below the start of the year, according to Merrill Lynch. The $2.5 trillion market for companies with high credit ratings, the investment-grade market, has fallen 11% since the start of September, and 11.5% since the beginning of the year. Such unprecedented drops suggest these markets could register their worst year in decades, and reflect strong fears about the U.S. economy. Stocks, meanwhile, slid for the eighth straight day Friday to their lowest close since April 2003. The Dow Jones Industrial Average finished down 128 points, or 1.5%, at 8451.19, capping the worst week in its 112-year history and down 22% this month. The market tumbled more than 600 points at the opening, falling below the 8000 mark for the first time since April 2003, but rebounded as investors came to expect more government action to save the financial system. The market swung more than 1,000 points from its low to its high, the biggest single-day swing in the Dow's history. Financial stocks ended the day up, and were the best performing sector in the market. Many types of debt, including agency mortgage-backed securities and corporate leveraged loans, tumbled Friday as banks, hedge funds and other investors were deleveraging, or unwinding their debt holdings. Banks that provided financing to help hedge funds purchase assets are asking customers to put up more collateral to back their positions -- or sell them, which pushes prices down further. "The corporate-bond markets are forecasting the worst recession since The Great Depression," says John Lonski, economist at Moody's Investors Service, noting that companies' borrowing troubles can lead to lower employment and curbs on economic growth. According to 24 years of Merrill Lynch data, the worst year for junk bonds was a 5% drop in 2000, as the technology-stock boom was waning and tech companies faced bankruptcy. The worst year for higher-quality corporate bonds was 1994, when that market declined 3.3%, a year when the Federal Reserve was raising interest rates, thus crimping the flow of credit. Investors are reacting to the latest turbulence by pulling money out of corporate-bond mutual funds, many of which have fared poorly this year. Individual investors have pulled nearly $6 billion out of investment-grade mutual funds since the start of September, and more than $1 billion from junk-bond funds, according to AMG Data, a service that tracks cash flows in and out of mutual funds. The $5.2 billion Vanguard Long-Term Investment Grade fund is down nearly 9% so far this year. The $15 billion Loomis Sayles Bond fund, which includes some junk bonds, is down 22% since the start of the year. Some with a strong stomach see an opportunity to buy. Brian Hessel, a partner at money-management firm Global Credit Advisers, says he has cautiously waded into the market to buy non-financial corporate debt that he feels has been "thrown out with the bathwater." The average price of a junk bond is just 69 cents on the dollar, resulting in a yield of 17%, according to Merrill Lynch. For an investment-grade bond, whose market has been dragged down by beleaguered banks and financial institutions that comprise 40% of it, the average price has fallen to 87 cents on the dollar, to yield 8.5%. Not since the 1980s have bonds been yielding so much, and that was a time of high inflation and high interest rates. In terms of spreads, or junk bonds' premiums over ultra-safe Treasurys, spreads were 11 points above Treasurys at the worst moments in 1991 and 2002, according to Merrill Lynch. In those periods, 10% of the market defaulted. Junk bonds currently yield 14 percentage points above Treasurys, yet default rates were just 2.7% of the market through August, according to Standard & Poor's. For investment-grade bonds, the average spread over Treasurys is unprecedented, currently 5.35 percentage points. Defaults are likely to rise as the economy weakens. By the end of 2010, 23% of the junk bonds that exist today will have defaulted, according to S&P's research. Companies of all kinds, already straining to meet near-term obligations due to seized up short-term markets like commercial paper, face even more trouble paying off longer-term debt. Meanwhile, the only safe asset class seems to be U.S. government debt, a blend of which has returned 4.5% so far this year, according to Merrill Lynch. Its Treasurys index has returned 10% since August 2007.