Don't Jump on Junk Bonds

It has been a tough year for stock investors, and it has also been a difficult time for owners of high-yield, or junk, bonds.

While this year's returns for high-grade and government bonds are anywhere from 5% to 8%, the total return (that is, annual yield plus or minus any gain or loss in the price of the bond) for many junk bonds is down by the same amount. But with yields for many above their 1998 highs, there was a discussion last week in the Realmoney.com Columnist Conversation as to whether junk bonds now offer good value.

Yields for many are in the low- to mid-teens, which would seem to make them a tempting target. Yet a look under the hood reveals that they might not be as attractive as they seem.

The junk-bond market is relatively new, having gained prominence in only the past few decades. Before that, there were few junk bonds issued; they were usually spawned from companies whose credit ratings had fallen below investment grade. Most institutional investors were not allowed to own bonds without an investment-grade rating, so they were forced to sell them into the marketplace. The significant gains that could be realized from buying low-priced high-yield bonds began to attract more investors, and a market developed.

This market, meanwhile, has undergone several transformations. In the 1980s -- the heyday of Michael Milken -- junk bonds became a financing tool. Many companies were bought out or taken to the private sector by issuing bonds supported by a relatively thin equity base. In the 1990s, junk bonds became important to capital formation. Many young and growing companies in industries such as cable, competitive local exchange carriers, Internet service providers and wireless operators met their capital needs through the junk bond market, instead of relying on the usual bank funding.

Current Woes

This latest development is the source of the current concern. Junk-bond issuers, by definition, have a smaller cushion than their highly rated brethren. More of their capital structure consists of debt, and that debt is funded at relatively high rates of interest. That's a tough enough burden for a company that intends to visit the capital markets only once. It's even harder for a growing firm that needs to borrow on a regular basis, because it might not get a welcome reception in the bond market on subsequent go-rounds. This is what is happening now.

There seem to be three negative forces at work in the junk bond market:

The first is the financial strength of those companies that are borrowing. Many were growing rapidly and, as this earnings season has shown, business does not seem to be as good this year as last. This slowdown may be only a hiccup to a company like Texas Instruments (TXN:NYSE - news - boards), but it could mean a life-or-death situation for a highly leveraged firm. The first rule of bond investing is to make sure that you get your money back. So the current earnings weakness has made bond managers less willing to carry the debt of newer companies. Many of those firms have not yet built their businesses and need continuous access to the capital markets. An inability to borrow now could send them off a cliff.

The second factor seems to be a general lack of demand for junk bonds. As the federal budget began to swing from deficit to surplus in the late 1990s, corporate borrowing began to soak up the freed capital. Private-sector borrowing is more productive than government borrowing, so this shift generally has been considered positive. Still, many institutional investors are limited to investment-grade bonds because they don't want to take risks with the fixed-income portion of their portfolios. This limits the pool of buyers for high-yield bonds.

Buyers that are in the pool, therefore, are heavy with junk bonds already. Large insurance companies can buy only so many junk bonds before their own credit ratings feel pressured. Pension plans are not making major shifts to the junk-bond market, and junk bond mutual funds are starting to see redemptions. As with any market, lower prices are the result if there are many sellers and few buyers.

The third factor is a lack of liquidity. After the Russian crisis of 1998 caused corporate bond prices to tumble -- and yields to spike up -- bond dealers trimmed their inventories. They realized that trading in bonds is a thin-margin business and have committed their capital elsewhere. This is good for the dealers, because they are now less exposed to the junk market. Unfortunately, it is a negative for the entire bond market, but especially so for the junk sector, which is less liquid than investment-grade or government bonds.

Liquidity will probably get even worse in the next few months. Financing in the bond market is always difficult at year's end. In recognition of this, most dealers have switched to a November fiscal year, and are reluctant to build inventories in the weeks leading up to the closing of their books. As a result, liquidity will be especially tight from mid-November until early January. Good bond managers know that liquidity is tight at year's end, so they hold enough cash to meet normal redemption patterns, but an increase in the level of withdrawals could cause a problem.

The combination of these things indicate that junk yields are not as attractive as they seem. As pointed out by Martin S. Fridson, chief high-yield strategist at Merrill Lynch in The Wall Street Journal last week, one in four junk bonds is trading at distressed levels (this means they are yielding at least 10 percentage points above comparable-maturity Treasury bonds). And that, in turn, is an indicator of future defaults. If defaults increase, then investors earn less than the current yield. Higher defaults, in turn, could lead to more selling in a thin market.

The situation is not totally bleak because these problems are currently confined to the junk sector. The high-grade corporate bond market is more than four times the size of the junk market, and those yields have fallen this year. This presents opportunities for companies with good cash flows and strong balance sheets, since they will be much more competitive than their weaker counterparts. I have started to see a gap in the stock market this year between the winners and the losers, and the turmoil in the junk market will probably intensify that.

At some point, the junk market will start generating positive returns again. It's tough to tell whether that will happen in 2001 or later, and from what level of defaults that will start. But even then, there could be better opportunities for investors than in the junk market. When high-yield bond rates start to come down, that will give a tremendous kick to the earnings of highly leveraged companies. Those with an appetite for risk will probably get more bang for the buck by owning the stocks of those companies rather than the bonds.

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Brian Reynolds is a certified financial analyst with more than 16 years experience as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at Brian Reynolds .