More risk than reward in junk bonds

by Levi Folk | January 29, 2007

It is probably not a great time to buy high-yield bonds, probably about as bad as it was 18 months ago when yield spreads were equally tight. Then, an 800-pound gorilla dropped into the high-yield debt market when General Motors debt was downgraded to junk status, swamping the market overnight. Yield spreads widened and high-yield bonds suffered a setback.

After resuming their downward trajectory, we are roughly back to that point, just prior to the GM downgrade, when yield spreads were very tight, suggesting there is more risk to contemplate than gains to pursue.

Investors are getting compensated less and less in recent years for owning lower-quality corporate paper. High yield bonds pay a yield premium over investment- grade debt (rated BBB or higher), but that spread is now razor thin.

To get an idea of just how far yield spreads have come down, the premium paid over government bonds is now quoted in basis points (100th of a percent) rather than the typical percentage points. Less than five years ago U.S. and European yield spreads were reflecting economic weakness and rising default rates, offering a hefty premium, in excess of 12%, over government bonds, according to Standard and Poor’s and The Financial Times.

The big move down occurred in 2003 and 2004 as yield spreads on high-yield bonds averaged roughly 4% percentage points. Those spreads were shaved even tighter in 2005 leading up to the GM downgrade, which is highly unusual given that the federal funds rate (in the United States) was ratcheted up repeatedly in 2004 and 2005.

Yet high-yield spreads continued their decent from 393 basis points in June, 2004, to 284 basis points last week, according to John Lonski, chief economist at Moody’s Investor Services.

Short-term interest rates may be up, but credit remains cheap, a theme I touched on recently in this column. Lonski calls the high-yield spread “a trustworthy barometer of financial liquidity” which tells him that “The Fed has really not tightened enough to reduce the supply of liquidity.”

Indeed, there appears to be too many lenders these days eager to pick up a few basis points off corporate borrowers.

There is no shortage of high-yield paper given the record corporate merger and acquisition (M&A) spree that we are bearing witness to, $3.7-trillion in deals in 2006 topping even the frothy levels reached in 2000. This has led to a more dubious record of sorts: the number of ratings downgrades by Moody’s associated with M&A activity. That subset of downgrades “swelled by 39% annually to a record 68 which easily surpassed 1999’s former zenith of 55,” according to Moody’s.

Private equity deals have fuelled the borrowing binge because the typical deal is financed with a little equity and a lot of debt. The implication here is that the more aggressive private equity deals are most at risk to default over the near to medium term due to the generous amounts of balance-sheet leverage.

Tellingly, triple-C rated paper, the least creditworthy category of high yield debt, has been swelling over the past few years, according to Leverage World newsletter as quoted in Grant’s

Interest Rate Observer. Lower default rates coincided with less risky paper issuance in the 1990s but that appears not to be the case in 2006, with triple- C rated paper rising to 15.7% of total issues. In other words, credit may be cheap but not necessarily less risky on average.

To be clear, an increase in the number of low-quality borrowers does not necessarily provide lessons for the rest of the high-yield debt market.

“A Caa bond (triple-C) is like an individual who has very bad habits,” says Lonski. “He smokes and drinks heavily and then suddenly drops dead and nobody is surprised.”

“What would rock the credit markets is a prominent ‘fallen angel’ downgrade that sinks into default like an Enron or a WorldCom.” The next credit-cycle slump will likely be initiated by the default of a prominent borrower. Lonski points to the Russian debt default in 1998 as another example.

With so few defaults in recent years, investors have been lulled into complacency. The average rate of default in 2006 at less than 2% is well under the historical average of 5% and a far cry from the 10% rate last seen in the 2002.

We can anticipate the default trend by looking at general levels of corporate health. Lonski is reassuring on this point. Cash flow (EBITDA) “remains ample” compared to net interest expenses, and “aggregate measures of corporate financial health tend to support the current thinness in spreads.”

“The only difficulty is that it is going to be difficult to sustain these robust aggregate readings on credit worth, and they are likely to soften somewhat.”

The U.S. economy is slowing and earnings momentum is likely to follow, which makes it difficult to see how credit spreads can get squeezed any tighter. With little opportunity for marginal gains in the sector there’s probably little sense staying seated in case another gorilla comes crashing through the ceiling.