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.
See more information on bond trading from Briefing.com
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.
Treasury Securities
Treasurys ended sharply lower as remarks by Federal Reserve Chairman Alan Greenspan fueled fears that the tight U.S. labor market will eventually pose a risk of inflation.
Mr. Greenspan said at a banking conference sponsored by the Federal Reserve Bank of Chicago that the declining U.S. jobless rate "constitutes a critical upside risk to the inflation outlook because it presumably cannot continue without eventually putting increasing pressure on labor markets and on costs."
Even though his overall speech was taken as a balanced one that signals no imminent change in the Fed's monetary policy, that particular remark triggered fears that the April employment report due to be released Friday will prove stronger than prior expectations, increasing odds that the robust growth will fuel inflation.
In trading late Thursday, the benchmark 30-year Treasury stood at 92 11/32, down 1 2/32, or $10.625 for each $1,000 face amount. The yield rose to 5.783% from 5.703% late Wednesday, as yields move inversely to prices. The yield saw a session high of around 5.80%, a level not seen since June 1998.
In other credit markets:
Corporate bonds rose as new issues from a Xerox unit and Texas Utilities Eastern drew heavy interest.
Yields on mortgage-backed securities tightened vs Treasurys, even as the overall market fell despite a late buying spurt.
Municipal bonds lost ground in nervous trading as investors focused on the possible growth of U.S. inflation.
In the Eurobond market, rate announcements in the United Kingdom and the euro zone damped bond sales in many European currencies. |
