Outlook Grim for Bonds Near Junk Status
Sunday July 14, 8:18 AM EDT
By Dena Aubin
NEW YORK (Reuters) - Warning: the line between junk and high-grade bonds is blurring, and if some economists are right, the trend could dampen the speed of the U.S. economy's current recovery.
Against a backdrop of faltering investor confidence, a number of companies that rely on the bond market for refinancing have seen their bond prices plummet and yields soar to junk-like levels, despite having investment-grade ratings.
Though the economy is not facing a broad credit crunch, the trend of soaring yields on investment-grade bonds means that a host of companies just a notch above junk could have trouble finding buyers for their bonds.
In a worst-case scenario, that could raise borrowing costs, delaying investment and retarding an otherwise healthy economic recovery.
"Most economists are still kind of optimistic about the economy, but it throws a real fly in the ointment that investors are much more wary of anything Wall Street is telling them," said Peter Kretzmer, senior economist for Banc of America Securities.
"This seems to be the headwind that is now facing the economy -- rather than a banking crisis or a savings and loan crisis like we had in the early '90s -- now it's this corporate-credibility issue."
Last year's bankruptcy of Enron Corp. (ENRNQ) and a stream of accounting fraud revelations at WorldCom Inc. (WCOME) and other firms have made investors wary of companies that could face refinancing risks. Even such Fortune 500 companies as AOL Time Warner Inc. (AOL) have seen their bonds trade to junk-like levels as investors flee companies with balance sheets that have grown debt-heavy and complex through acquisition sprees.
An investment-grade rating -- even the lowest of the class at triple-B -- used to mean that a company could be counted on to pay back debt when it matured, even if that meant selling more bonds to retire the old ones. But with markets in turmoil, the ability to sell bonds has become an iffy proposition for companies at the lower end of the investment-grade world.
ACCOUNTING FEARS HIT AOL
"In 1998, before Russia defaulted, even double-B companies could go into the market and basically command terms they wanted," said Robert Grossman, chief credit officer for Fitch Ratings. "Now, a single-A is almost the rating you need to assure yourself access."
As distrust of corporate accounting deepens, companies that depend on the credit markets to roll over debt are finding that investors no longer trust that they can.
"Companies in industries that have had a tremendous amount of consolidation, growth through acquisition and have issued a lot of debt are under close scrutiny," said Peter Palfrey, senior portfolio manager for Loomis Sayles & Co. in Boston.
Fears about corporate accounting stoked selling in AOL Time Warner's bonds last week, causing its 10-year paper to trade as wide as 4.50 percentage points more than Treasuries, or at a yield of about 9.23 percent. That is close to the 9.42 percent average yield for junk bonds in the mid-tier "B1" range. AOL's yield spreads have since come in to about 3.60 percentage points since the company disclosed it had secured a new $10 billion credit facility.
AOL is not alone.
Triple-B rated bonds of a large swath of the telecom, energy trading, pipelines and cable sectors also are trading at or near junk-bond yields.
PIMCO'S GROSS WARNS OF TRIPLE-B'S RISK
Even influential investor Bill Gross, head of the world's largest bond fund at Pacific Investment Management Co. (PIMCO), has been caught up in the carnage, seeing the market value of his funds' $2 billion Sprint bonds decline sharply in the wake of accounting scandals.
"If you can't handle a downgrade to junk status, perhaps Baa-rated bonds should be off your plate as well," Gross wrote in an investment outlook on PIMCO's Web site.
Problems are likely being exacerbated by hedge fund managers who are short-selling bonds of companies that are temporarily in trouble, Gross said. Selling short refers to the practice of selling borrowed bonds in the hopes of buying them back after prices fall.
Hedge fund selling can even start a vicious cycle of plunging bond prices, which can prompt downgrades to junk, and an even worse price rout, Gross said.
Paul McCulley, a managing director at PIMCO, warned in a separate report that the economy could be hurt if funding dries up for companies that now rely on issuance of new debt to retire bonds. Increasingly, though, lenders are demanding that companies be able to pay interest and retire outstanding debt from internal cash flow, he said.
"This is the emerging and frightening paradox of our times: for a company to prove that it is a going concern, it must prove that it could liquidate itself," he said. "Capitalism can't function on this basis."
Growing refinancing risks have prompted Fitch Ratings to change the way it reviews triple-B companies, Grossman said.
"We're starting to look at triple-B companies like high-yield companies, which means greater discipline on funding and cash flow and matching of assets and liabilities," he said.
Ironically, the bond market's troubles are happening at a time when signs are pointing to a stronger economy and corporate profits are edging higher.
"There is a divergence between that outlook and what's going on in the bond markets, and that leads me to think we may well be at the point where it's overdone," said Richard Waugh, economist and research director at Principal Capital in Des Moines, Iowa. "The massive revaluations in bond prices that have been going on may be at the point where we're at the final selloff." |
