Mom And Pop May Be Rushing Into US Junk Bonds At The Top
11/12/2004
Dow Jones News Services
(Copyright © 2004 Dow Jones & Company, Inc.)
By Tom Sullivan
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--Few think of speculative-rated bonds as a widows-and-orphans type of investment, but the high-yield market is attracting new investors despite the risks involved in owning speculative-grade-rated securities.
And Mom and Pop may be venturing into junk bonds just as they are hitting a top. The high-yield market, which has outperformed other fixed-income classes this year, may become a victim of its own success - with prices too high and yields too low to reap another year of positive returns, especially in a rising interest rate environment.
High-yield bond mutual funds saw inflows of $601.5 million in the week ended Wednesday, the largest single week of money coming into the funds since October last year, according to AMG Data Services in Arcata, Calif. In fact, since a disastrous spring - a time when the market fretted over a possible sharp ratcheting up in interest rates - high-yield bond funds have enjoyed a net inflow of $4.46 billion from June 1 to Nov. 10, according to AMG.
This week's surge of inflows comes at a time when J.P. Morgan's high-yield index is yielding around 7.14% - near an all-time low; the average junk bond price is trading well above par; and the average composite yield margin of a risky high-yield bond is at 3.20 percentage points over ultra-safe Treasurys, the narrowest since the peak of the last high-yield rally in 1997, according to credit rating agency Moody's Investors Service.
"By most measures the market is overpriced, and investors are not being fully compensated for the considerable risks of below-investment-grade bonds," said John Lonski, chief economist at Moody's.
The inflows also come at a time when default rates in the U.S., while still historically low, are creeping up: The default rate stood at 2.9% in October compared with the cycle's bottom of 2.6% in August, according to Moody's. And so far this quarter, Moody's downgrades of speculative-rated companies have outpaced upgrades - reversing the trend of the second and third quarters and indicating that credit quality may be on the downtrend, although Moody's forecast that the global default rate will be unchanged in 2005 at 2.4%.
"The market has priced in a good deal of favorable news that may or may not materialize," Lonski said.
The lofty market levels prompted Goldman Sachs this week to close its long positions in high yield - bets that the market will continue to rise - and to move to an underweight position, warning in a research note that "spreads are projected to rise from here." Goldman also slashed its allocation to global high yield to 2% from 8% of its model portfolio.
Goldman issued the warning the same week it successfully underwrote a new offering from a company called AAC Group Holding, rated a highly speculative Caa1 by Moody's. The company raised $89 million through a sale of senior discount notes that gave investors a 10.25% pay-in-kind coupon - paid in more debt rather than cash. And the proceeds went to private equity buyers to pull cash out of a company they had bought just nine months ago.
The deal from AAC, the holding company for American Achievement Corp., an Austin, Tx.-based maker and supplier of school-related affinity products like class rings, yearbooks and graduation products, was reminiscent of the high-flying days of the late 1990s, before the high-yield market collapsed with the bursting of the technology and telecommunications bubble.
Then too, the search for yield was the paramount concern.
"At this stage, there's nothing high in high yield," said Marilyn Cohen, president and portfolio manager of Envision Capital Management in Los Angeles, which advises individuals investors. "There's absolutely no upside" in the junk bond market, she said, adding that she's advising clients to mostly stay away from the asset class.
But "Mom and Pop are absolutely starved for yield," and they see speculative-rated bonds rally while their savings languish in paltry-paying money market funds - creating temptation.
'Mission Accomplished'
The high-yield market has turned in a total return of 8.72% year-to-date through Nov. 10, according to the Merrill Lynch U.S. High Yield Master II Index.
"It's the best performing fixed-income asset class," said Harry Resis, head of U.S. fixed income at U.K.-based Henderson Global Investors, with $500 million invested in high-yield.
"At these levels it's hard to be bullish, but the market's up about 9% and we're earning our coupon," as many in the market - including Resis - predicted would happen after last year's near record returns. "Mission accomplished," he said.
Looking ahead, "credit risk is as low as it has been in a long time," said Resis. And even though the Federal Reserve is in rate-hiking mode, he doesn't see Treasury yields in the seven- to 10-year part of the curve moving up beyond 4% to 4.5% next year.
He cited the recent past for his outlook.
For the first time ever, the Fed has tightened four times and the 10-year rate has moved lower - to 4.20% now from 4.60% on June 30, Resis said.
New high-yield bonds are usually priced at a yield margin, or risk premium, over seven- or 10-year Treasurys.
What's more, supply this year has fallen back, totaling just $116.4 billion - trailing last year's amount for the same period by about $2 billion, according to data supplied by Thomson Financial in New York.
Still, if interest rates were to hit 5% or higher, the higher yields achieved on new issues would likely pressure the secondary market - sending prices lower and yields higher to match the new deals.
-By Tom Sullivan, Dow Jones Newswires, 201 938-2048; |
