Junk Bonds' Strength Belies Balance Sheets

A recent study by Moody's showed that the average rating of American firms has fallen over the past three years from the lowest investment-grade rating to junk. And a study by CreditSights concluded that total debts for a sample of 175 firms are nearly 40% higher than they were in 1999.

Adding to the concern, corporate profit growth is expected to decelerate over the coming year, and the economy has been showing signs of fatigue lately. Retail sales have been sluggish in recent months, and employment gains have been disappointing. Even though the Federal Reserve has raised interest rates twice this year, yields on Treasuries have fallen sharply, suggesting that the economy may be slowing down.

"The bond market is telling us that the economy is much weaker than [Fed Chief Alan] Greenspan is letting on," said Roberts.

In testimony before Congress this week, Greenspan said the economic expansion has "regained some traction." Yet investors have remained leery, snapping up risk-free assets such as Treasuries. The yield on the 10-year note has fallen to 4.2% from 4.9% in June.

"I would be willing to buy junk bonds when the economy is in a strong state of recovery as we were witnessing in 2003, when my risk of default is the lowest," Roberts said. "However, if the economy begins to slow, or worse yet, return to a state of recession, as the bond market may be signaling, then the risk of corporate defaults begin to rise."

Martin Fridson, an independent high-yield debt consultant and publisher of Leverage World, said defaults are likely to increase next year because the quality of new junk issues in 2002 was poor. On average, he said, it takes about three years for companies to default.

He also agrees that price appreciation will be limited this year but said high yield still makes sense, given the lack of viable alternatives. "A coupon of 7% or 8% for the year looks pretty good relative to stocks," he said.

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