More on the corporate credit crisis and junk bonds:
Credit "blowups" a big cause of corporate bond ills
By Jonathan Stempel
NEW YORK, Oct 23 (Reuters) - Whether called "blowups," "bombs" or "land mines," corporate credit problems are causing broad pain in the U.S. corporate bond market, and the worst may not be over, according to two leading Wall Street investment banks.
Merrill Lynch & Co. and Salomon Smith Barney said blowups resulting largely from disappointing earnings or sales, real or threatened, show investors punishing bonds much as they have stocks, with zero tolerance for mishaps.
"In our view, the market is experiencing typical late credit cycle phenomena," wrote Merrill Lynch. "The random nature of the credit events that have plagued the credit market all year equates to a rise in overall market risk."
Both reports, issued on Friday, said more woes are probably in store. But that may not be reason to avoid corporate bonds altogether, experts said.
"You have to be a little more selective than to simply say you don't like the corporate bond market," said Eli Lapp, senior vice president and corporate bond strategist at HSBC Securities Inc. in New York. "You cannot taint the entire market with a negative brush because of blowups."
But some investors already have done so.
CORPORATE BONDS WEAKEN
Blowups are corporate bonds that quickly and sharply fall in value, often so much that traders quote them by price, like junk bonds, rather than by spread, or their yield premiums over safer U.S. Treasuries, like other investment-grade bonds.
An example are Xerox Corp.'s (NYSE: XRX) 5.875 percent notes maturing in 2004. The copier maker, expected to outline a turnaround plan on Tuesday, still carries low investment-grade ratings, but the notes trade at just 75 cents on the dollar.
Merrill Lynch identified 27 blowups this year, comprising 3.1 percent of its main corporate bond index and affecting $32.3 billion of bonds. These bonds fell an average 31 percent, costing investors nearly one percentage point of return. The index is up 6.07 percent through Friday.
Meanwhile, using different methodology, Salomon found 60 blowups contributing 0.59 percentage points, or 26 percent, of corporate bonds' 2.24 percentage point underperformance relative to Treasuries. So many bonds have blown up that few bond investors could have avoided owning one, it wrote.
It noted, though, that the shortfall accounts only for declines in the months the declines occur. That means blowups' impact on this year's market may be even greater.
As a whole, that market has been hit hard this year.
Most of this year, spreads have widened--by more than 1 percentage point on even widely-owned bonds from AT&T Corp. (NYSE: T) and Ford Motor Co. (NYSE: F) --to levels not seen since the 1998 financial crisis following Russia's debt default. In just the last two weeks, they widened about 0.15 percentage points.
Bonds often sink for fundamental reasons. Retailers with falling profit margins and sales, such as Dillards Inc. (NYSE: DDS) and J.C. Penney Co.(NYSE: JCP), have seen their bonds blow up. So have finance companies with weakness in loan portfolios, such as Conseco Inc. (NYSE: CNC) and Finova Corp. (NYSE: FNV).
Other blowups, though, result from fear that problems affecting one company will affect others.
When Owens Corning's (NYSE: OWC) bonds sank after the building materials maker filed for bankruptcy protection to ward off asbestos-related lawsuits, bonds of Armstrong Holdings Inc.(NYSE: ACK), Owens-Illinois Inc. (NYSE: OI) and others with asbestos litigation exposure did the same.
THE FUTURE
It's no time to celebrate a market bottom, experts said.
Stock market volatility, falling liquidity, rising energy prices a strong dollar and spreads too narrow to account for more negative surprises leave Merrill Lynch cautious. It said investors should favor bonds from sectors less volatile than the market, such as aerospace and defense, or oil and gas.
Salomon seeks a "catalyst" to stop the deterioration, such as bond market prices that fully reflect declines in corporate credit quality, higher equity valuations and better liquidity. "Our belief is that there is more work to be done," it wrote.
Lapp saw no catalyst either, but said things would not get much worse as long as U.S. economic growth doesn't slow too much.
"I expect the market to tread water from now to year end, when hopefully people will take a fresh look," he said. "If we see a soft landing, my scenario stays intact. If the landing is harder, all bets are off."
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