EARLY maybe but accurate..as time will tell.
Bond Believers See Prelude to a Fall
nytimes.com
November 19, 2000
By GRETCHEN MORGENSON
When the bond market talks, investors don't always like to listen.
After all, bond investors tend to spot bad news on the horizon and
then telegraph it to the rest of the world in language as complex
as Alan Greenspan's when he testifies before Congress.
But with the stock market in a swoon, investors looking for
guidance are starting to heed the distress signals that the bond
market has been sending up recently. And what some observers fear
they see in these signs is a storm for the United States capital
markets that may be tougher to recover from than the debacle in the
autumn of 1998.
That year, a crisis was precipitated by the demise of one giant
hedge fund, Long-Term Capital Management. But after the Federal
Reserve Board lowered interest rates, recovery came swiftly to the
stock market and the economy was relatively unscathed. This time
around, market observers say, the turbulence will be set off by
many troubled companies buckling under the weight of excessive debt
lent to them at the height of New Economy euphoria.
That scares the pinstripes off the pants of some who heed the bond
market's signals. If worried investors continue to shun corporate
bonds as they turn away from risk, many companies will find it
impossible to raise the capital that leads to new job creation and
continued economic growth. And since much of the economic growth in
this nation over the past few years came from the big money spent
by companies that had raised cash in the anything-goes bond market,
the economy could slow quite sharply as the money spigots go dry.
Finally, as more and more companies go under, their woes could
turn a soft economic landing into a much bumpier one. And the
longest American expansion on record could come abruptly to an end.
Byron Wien, chief United States investment strategist at Morgan
Stanley Dean Witter, sees little good in the signals the bond
market is sending.
"One," he said, "the hard landing possibility for next year is
more realistic than the stock market believes. Two, even if there
is a soft landing, corporate fixed expenses have built up during
this nine- year period of prosperity and will be hard to roll back,
so that a minor shortfall in revenues will cause a major shortfall
in profits."
The bond market's condition has implications for interest rate
policy as well. "This is a murky picture and even contributes to a
more difficult judgmental problem for the Federal Reserve," said
Henry Kaufman, the Wall Street economist. Before the Fed can cut
rates, he said, it must weigh the decline in credit quality against
the need to get the market moving again.
The corporate debt market has grown enormously in recent years,
expanding to accommodate the burgeoning capital needs of hundreds
of companies. Although most investors focus on the stock market,
the corporate bond market dwarfs it in size.
And the gap is widening. So far this year, companies have raised
only $146 billion from new stock issues, compared with $935 billion
in the corporate bond market, according to Thomson Financial
Securities Data. The peak of corporate issuance came in 1998 when
$1.2 trillion worth of bonds came to market, up from $433 billion
raised in 1995.
But lately, issuance has slowed considerably as the roster of
troubled companies has started to swell. Just last Tuesday, ICG
Communications, a telecommunications and internet service provider
in Englewood, Colo., filed for bankruptcy. The company, whose stock
had traded as high as $39 a share last March, had $2.2 billion in
long-term bonds on its balance sheet before the bankruptcy.
And, to cite just one other example among many, on May 17, GST
Telecommunications, a Vancouver voice and data services provider,
declared bankruptcy. Although Time Warner bought its assets, it
paid only 70 percent of the book value of the company's plant,
property and equipment. That left just 50 cents on the dollar for
bondholders.
As bond investors have digested those corporate difficulties,
their appetite for risk has shrunk markedly. Many companies needing
cash and willing to pay high interest rates for it have been out of
luck. The total amount of money raised in high-yield bonds this
year will probably be around half the $99.7 billion raised in 1999,
according to Merrill Lynch. In October, only seven high-yield bond
issues came to market, raising a total of $1.63 billion. In October
1999, 17 high-yield bond issues raised $3.3 billion from investors.
Meanwhile, the sickliness of the corporate bond market is also
seen in the rising interest rates that high- yield issues must pay
to attract investors. According to Merrill Lynch, such bonds now
yield 13.34 percent, up from the 10.3 percent demanded by investors
in September 1998, when Long-Term Capital Management was sinking
and the capital markets stood still. And high-yield bonds are
trading at yields that are almost 9 percentage points higher than
comparable Treasury securities. The difference between those two
yields is called the spread.
Today's high yields and high spreads suggest that investors
realize that many companies issuing high-yield debt confront much
greater risks than they faced two years ago. That is because in the
crisis of 1998, even though one big participant was teetering, the
overall balance sheets of most issuers remained healthy. Then, the
underlying credit fundamentals of high-yield companies were better
than they are now, according to Ravi Suria, the convertible bond
analyst at Lehman Brothers who became famous for his in- depth and
scathing report on Amazon.com last June (from which its stock never
recovered). In a recent report on heavy debt among
telecommunications companies, he argues that the market's current
problems will be more difficult to emerge from. He said that is
because the problems are tied to declining credit quality of
underlying issuers that have continued to add leverage in the face
of falling growth rates.
Diane Vazza, head of global fixed income research at the Standard
& Poor's Corporation, agreed: "We are now in the 10th consecutive
quarter where we have seen downgrades of corporate debt outpace
upgrades. The last time we saw that was in 1990-1991, when we had
11 consecutive quarters of downgrades during a period of record
defaults."
Some things are already worse. Last year, Ms. Vazza said, 89
companies with debt that was rated defaulted on $24.2 billion in
securities; so far this year, 85 companies have defaulted on almost
$24.7 billion of debt. In 1991, when the country was in a
recession, 65 companies defaulted on $19.8 billion of debt.
Adding to the unease over the higher default figures of today,
companies are defaulting on their bonds more quickly than they have
historically. Mariarosa Verde, a director in the loan products
group at Fitch, a bond rating company in New York, said: "We looked
at defaults by issuance date and found that 84 of the 152 bonds
that defaulted this year were issued in 1997 and 1998. That's 55
percent, which is very significant."
For most of the 1990's, high-yield issuers have defaulted in four
years on average, not the two to three years that is becoming
common. What these companies are running into, Ms. Verde said, is
an unaccommodating market just when they need to refinance.
There's another measure by which things appear worse today than
in the recessionary period of 1990: how much lenders are recovering
after a company emerges from bankruptcy. Robert J. Grossman, group
managing director at Fitch, said his company had tracked recoveries
made by lenders between 1991 and 1997. He found that lenders
holding unsecured debt those that stand well back in the
creditors' line got back on average 40 cents on the dollar
invested.
But, in the past three years, unsecured lenders have received 23
percent less on average, or 31 cents on the dollar, because
defaulters are so overextended. "The asset values just aren't
there," Mr. Grossman said.
Perhaps the greatest surprise to bond investors has been the
seemingly overnight collapse of the credit ratings of once
high-quality corporations. "Coming out of left field, a number of
investment grade companies like Xerox, J. C. Penney and Laidlaw
fell off a cliff, going straight from investment grade to
distressed," said Martin S. Fridson, chief high-yield strategist at
Merrill Lynch.
Some investors fear that the woes of such former blue chips may
signal a looming recession, but Mr. Fridson does not. He views the
distressed state of the bond market to be the result of too much
loose money chasing too many untested companies.
While the stock market partied heartily in recent years with
hundreds of initial public offerings that shot straight into the
stratosphere, the euphoria was even more evident in the high-yield
bond market, where companies of questionable credit strength go for
money to fund their operations. It has grown from $213 billion 10
years ago to $508 billion today, Merrill Lynch says far beyond
the growth of the economy.
Naturally, as the market ballooned, so did the risks. Jack Hersch,
a private investor in distressed securities in San Diego who ran
research at M. J. Whitman, a New York investment firm, described
the change in the junk bond market: "Ten years ago you had good
companies with bad balance sheets, that were overleveraged. Very
rarely did you have bad business models. Now in some sectors you
have truly bad business models, poorly run companies that may have
no reason to live."
Such speculation is one thing in the ephemeral world of dot-coms.
It is another in an economic backbone sector like
telecommunications, where most of the money needed for expansion
has been raised in the high-yield bond market. According to Merrill
Lynch, telecommunications bonds made up an astonishing 18.6 percent
of the market on Sept. 30. The next industry group, cable
television, had just 8.63 percent.
"The telecom area is venture capital masquerading as high-yield,"
Mr. Hersch said. "You had businesses that had good stories to tell
and only future earnings to point to." Now, those earnings are in
doubt.
Mr. Suria's report compares recent capital spending by telecom
companies with spending on other large infrastructure programs in
history railroads, highways, the telephone system and nuclear
power plants. He notes that the enormous spending by telecom
companies has never been done before in an unregulated, free-market
environment.
This is significant because regulated industries like utilities,
and monopolistic enterprises, like the railroads when they were
built, can bank on guaranteed income from consumers that can be
used to pay interest on the debt amassed to build the projects. But
given the intense price competition in telecommunications, Mr.
Suria wrote, lucrative cash flows from customers are no sure thing.
That makes many of these bonds precarious indeed.
The precipitous decline of technology stocks in recent months is
also contributing to the high-yield bond market's woes. That is
because investors who were willing to lend to speculative companies
took some comfort in their holdings as long as these companies'
stocks and overall market value were riding high.
"Through 1997, their franchise value or market value was growing
and the future outlook for these companies was improving enough
that they could add debt without it being too risky," said Allen J.
Levinson, managing director of K.M.V., an analytical and advisory
firm in San Francisco that specializes in credit risk. "Since then,
many of these companies have continued to add debt at a consistent
pace, but their market values have stopped growing or are growing
at a slower pace. As a result, the market leverage of the companies
has grown rapidly and so has their probability of default."
Mr. Suria is also troubled that other indebtedness that is not
easily identified is growing at many corporations. These less
visible forms of debt include so-called vendor financing,
increasingly popular at technology companies, and syndicated
lending by banks to new companies.
Vendor financing usually involved a company Lucent Technologies
is an example using its high-grade balance sheet to finance
equipment that it sells to customers with weaker credit profiles.
The buyer gets the equipment at much lower interest rates than it
would otherwise have been able to get from a bank.
But the seller takes on the risk of lending money to a speculative
company. And indeed, last month, Lucent warned investors that it
was increasing its expenses to cover bad debts from its customer
financing. The news sent Lucent's stock reeling, and it dropped 32
percent in a single day.
Syndicated lending by banks is also largely hidden from investors'
views, Mr. Suria pointed out. Last summer, federal regulators
reviewed large loans made by banks across the nation. They found
that classified credits, loans that are defined as substandard,
doubtful or lost, increased by almost 70 percent this year over
1999.
On Wall Street, there's another worrisome factor: As the
high-yield market has grown in recent years, the number of
brokerage firms and banks willing to trade the securities has
declined. Some of the decline stems from mergers in the financial
services industry, but even the firms that still stand ready to
facilitate their customers' purchases and bond sales have sharply
reduced the amount of money they are willing to offer for this
business.
Mr. Fridson estimated that since 1998, the capital that firms were
willing to commit to make secondary markets in high-yield bonds has
been slashed by at least 50 percent.
Another important change is that a much wider array of investors
now hold these high-yield bonds. In 1990 and 1991, that market
stumbled as the country sank into recession and the Resolution
Trust Corporation made matters worse by forcing savings and loan
institutions to sell their high-yield bonds at fire-sale prices.
Most hurt then were financial institutions that were holding these
securities; today, the risks in the market are more widely spread
among financial institutions, insurance companies, sophisticated
investors like those who put money in hedge funds and individual
buyers of high-yielding mutual funds.
This shift of ownership has good and bad aspects. On the plus
side, some financial institutions may wind up in better shape after
the next peak in defaults because they carry less of the total
amount of troubled securities than they did the last time around.
If these institutions are not at great risk, then the chances of an
economic meltdown are reduced.
But some analysts fear that even if Mr. Greenspan cuts interest
rates in coming months, it may not help this situation. The cost of
debt capital for high-yield telecom companies is 15.6 percent;if
the Fed eases by 200 basis points, it wouldn't substantially lower
their costs.
Furthermore, since the huge growth in capital spending that has
fueled economic growth in the United States was largely funded by
high- yield bonds, when the market freezes, it cuts off access to
capital. When a big growth engine stalls, the economy could get hit
hard. |
