Junk-Bond Market Delivers A Surprise: More Defaults
By GREGORY ZUCKERMAN
Staff Reporter of THE WALL STREET JOURNAL
Once again, it is clear why they call it "junk."
Lost amid the euphoria surrounding Dow 10000 and then Dow 11000,
and this week's slide in the Treasury market, is this disconcerting note:
Companies are defaulting on their bond payments at a rate that hasn't been
seen since the early 1990s. The rising tide of defaults is dealing some
painful blows to investors and threatens to damage what is currently a
strong market for junk, or high-yield, bonds.
Junk bonds, which are rated as
speculative investments by rating
agencies, pay higher interest rates to
compensate investors for the bonds'
higher risk.
The defaults, coming as they do in a
booming economy, are surprising.
While defaults rose last year, too,
that was attributed mostly to the
problems swamping emerging
markets. Now, however, companies
with no links to emerging markets
are starting to default. Just this week Vencor Inc., the giant Louisville, Ky.,
nursing-home chain, defaulted on payments on its junk bonds, sending
those bonds tumbling. Bonds of Vencor have fallen to 15 cents on the
dollar from 84 cents since January.
Economic optimists said "the rise in defaults last year was due to
emerging-market problems, but with U.S. defaults generally on the rise
now, especially in the telecom sector, that point is moot," says Martin
Fridson, chief high-yield strategist at Merrill Lynch & Co.
About 3.8% of companies that have junk bonds outstanding defaulted in
their payments during the 12 months ended April 30, according to
Moody's Investors Service Inc., up from 3.4% in calendar year 1998 and
2% in calendar year 1997. Moody's predicts defaults will top 4.5% this
year, the highest level since 1992 and above the 4.1% average since 1980.
Overall, 1.4% of companies with any kind of bonds outstanding defaulted
on bond payments in the past 12 months, up from 0.6% in calendar year
1997 and the fastest pace since 1992.
The problem, according to analysts, stems from the potent combination of
investors seeking higher -- read that, riskier -- returns and more small or
shaky companies seeking to finance themselves through the bond market.
That has led to growing issuance of junkier junk bonds amid record
high-yield bond sales in the past two years. A hefty 26% of the high-yield
debt sold last year came from companies that were unrated, or rated
single-B-minus or lower, according to Merrill, up from 21% in 1997 and
the highest level ever. (A single-B-minus rating is in the lower tier of junk
issues.) In less exuberant times, many such companies would have been
forced to turn to venture-capital firms.
Now that their debts are coming due, many are finding it difficult to make
their bond payments.
"There are some deals that clearly never should have gotten done," says
Arthur Calavritinos, who manages junk bonds at John Hancock Mutual
Funds. "We've already seen weakness in junk-bond prices ahead of the
defaults, and we should see more of it."
Adds Mr. Fridson: "Quality in the market is not dramatically better than the
1980s, contrary to what people promoting the high-yield market say."
Meanwhile, some companies that planned to come back to the market to
do follow-on bond sales are finding investors, still conscious of the beating
they took in junk bonds late last year after Russia defaulted on its debt,
uninterested. As the companies fail to find demand for their new debt, and
find they can't tap the stock market, some are defaulting on their existing
bonds. Forcenergy Inc., a Miami oil and natural-gas producer that filed for
bankruptcy-law protection in March, is one such company, according to
analysts. Executives of the firm didn't return a call seeking comment.
"If you don't have a dot-com at the end of your name, you will have
trouble raising money in the equity markets that would allow you to retire
debt," says John Lonski, a senior economist at Moody's. "And a lot of
speculative-grade issuers have been hurt by the weak pricing environment,
especially in the energy industry."
To be sure, the rise in defaults isn't spreading much beyond the weakest
ranks of issuers, at least so far. Many investors, wary of precisely the
defaults that have occurred, shifted their portfolios to favor stronger
high-yield companies. In fact, the market has charged ahead recently,
along with stock prices and the outlook for an improving global economy.
That has resulted in a narrowing of the spread, or difference, between junk
bonds and safe Treasurys to 4.70 percentage points from 5.03 in the past
three weeks.
Analysts expect the problems to grow but remain contained among the
weaker issuers, rather than spreading to resemble the default rates that
approached 10% of all junk-bond issuers in the early 1990s.
"The specter of another wave like 1990 -- when we had problems in
different sectors caused by overleveraged buyouts and then we got a
credit crunch -- doesn't look likely," says Mr. Fridson. "The problems
don't involve a majority of the market."
But others warn that rising defaults could weigh on the entire junk-bond
market this year. "Investors should be focused on the rise in defaults, and
on credit quality in general, because ever since the debacle in late summer
and fall, the market is more conscious of credits," cautions Kingman
Penniman, president of KDP Investment Advisors Inc., in Montpelier, Vt. |
