Junk Bond Market Weakens

But with default and interest rates still low, some see a buy signal.
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Updated from 2:29 a.m. EDT

It's not just stocks that are getting pounded. The junk bond market also has been taking a beating, and that could spell trouble for some cash-strapped companies.

Last week was the weakest since the beginning of the year for new junk bond issues. Thomson Financial reports that U.S. companies sold $1.2 billion in high-yield debt last week, compared with the weekly average of $2.9 billion this year.

The action in the junk bond market remains lackluster this week. As of Monday, there were just three junk bond deals on the calendar with a total dollar value of $850 million.

So far this year, companies have sold $55 billion in junk bonds.

More troubling, a number of companies, both in the U.S. and overseas, have postponed junk bond offerings because of unfavorable conditions. Some of the companies putting deals on ice include

Revlon

(REV) - Get Report

,

Samsonite

and European steel manufacturer

Corus

(CGA) - Get Report

.

Meanwhile, investors are racing to pull money out of junk bond funds. Last week, according to analysts at Wachovia Securities, investors took $2.2 billion out of junk bond mutual funds, the largest outflow of money since last August. Spreads on high yield bonds -- the difference in their yield above Treasuries --- have risen a third of a percent over the past two weeks.

The conventional wisdom on Wall Street is that the junk bond market is getting slammed by the prospect of rising interest rates in the U.S. Junk bonds tend to perform badly when rates are rising as yield-hungry investors turn to new, higher-yielding issues.

But it's not just rising rates that are crushing the hopes of junk bond investors and the dreams of struggling companies looking to raise new financing. Others say the junk bond market, just like the stock market, is a victim of the growing uncertainty about the war in Iraq and the impact of soaring oil prices.

"Higher oil prices and the situation in Iraq may be weighing on it more than interest rates," says John Lonski, Moody's Investors Services' chief economist. "As uncertainty increases, higher-risk securities tend to fall out of favor."

From an economic standpoint, Lonski says much of the anxiety about junk bonds appears overdone. Even with the

Federal Reserve

ready to begin tightening the money supply, interest rates are poised to rise from historically low levels.

Additionally, the current default rate by U.S. companies on junk bonds stands at 4.3%, down from 5.4% at the end of 2003. The default rate on junk bonds peaked during the recession at 11.6% in January 2002.

The trouble in the junk bond market could have wider ramifications, especially if the market for new issues continues to dry up. An inability of companies to tap the junk bond market for financing could imperil some pending corporate mergers and derail ones under discussion, says a trader with a merger arbitrage hedge fund.