Smaller Companies' Bond Recovery Has Limits

Small debt issuers are finding renewed interest in their bonds, but investors are demanding hefty premiums.
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The collapse of the corporate fixed-income markets, caused last fall when

Long Term Capital Management

imploded, is a thing of the past. And unlike the first few months of the corporate markets' recovery, smaller companies are attracting financing again.

But some analysts say the scope of this recovery has probably reached a limit, for the time being. The smallest and riskiest companies that do sell bonds are continuing to pay a higher price. The companies that carried the most risk -- what investors frequently referred to as "venture capital" -- haven't returned to the market.

Investors say their caution reflects continued uncertainty about the strength of the global markets. But they also say their apprehension isn't going to be short-lived, because they felt the credit markets too readily accepted unnecessary risks in late 1997 and early 1998.

"It's human psychology 101," says Jerry Paul, senior vice president and director of fixed income at

Invesco Funds

. "As the new risk manager

at an investment bank, if you saw your predecessor lose their job because they were taking high risks, are you going to raise the trading desks' limits? Did your grandparents forget the Depression? I don't think so."

Rethinking Liquidity

Once Russia defaulted and Long Term Capital disclosed the scope of its losses, investors sold securities in every fixed-income market, piling into Treasury bonds. Corporations were unable to sell bonds for a month, and the credit crisis caused underwriters to change their previously euphoric thinking.

Prior to the collapse, when underwriters couldn't generate enough interest to sell an entire new bond offering, they'd hold onto some of it, confident they could sell the bonds in coming weeks. When the crisis hit, dealers were caught with loads of inventory that was now trading at depressed levels -- losing them lots of money.

Dealers are no longer willing to shoulder risks when investors balk at risky deals, and at least a dozen small high-yield deals have been postponed this year. "That's one of the reasons there is still a barrier to entry," according to John Atkins, corporate analyst at

Thomson Global Markets

.

Investors don't want that risk passed onto them either. The fear of not having liquidity is still palpable, and so they've retrenched by demanding higher yields in exchange for holding a bond they might not be able to sell if the price fell sharply. The "everybody gets money" mantra, which became popular in early 1998, isn't going to return as long as people remember what happened at the end of that year.

"Buyers believed they weren't going to have a liquidity issue," says Paul. "It's painful when it happens. There's still access to the market. There's a lot of little deals floating around -- they just have to pay a premium."

Between 1995 and 1997, the yield on the average high-yield bond averaged 320 basis points, or 3.2%, more than the 10-year Treasury bond, says John Lonski, senior economist at

Moody's Investors Service

. That spread is currently about 400 basis points -- much tighter than in the fall, when spreads widened to 650 basis points, but still wider than at any other point since 1991. Investment-grade bonds are not immune either: The average corporate industrial bond currently trades at 140 basis points more than Treasuries, compared with an average of 87 basis points between 1995 and 1997.

Working Its Way Back

After the crisis, it took the sale of large, highly liquid corporate bond deals for investors to regain comfort with the added risk of corporate bonds. Through the first three months of 1999, jumbo-sized offerings, such as

AT&T's

(T) - Get Report

record $8 billion issue, were most easily accepted. The size of deals is significant because it directly impacts the liquidity of a corporate bond -- the smaller the issue, the more difficult it is to trade easily. The average size of an investment-grade bond offering through April 23 was $507 million, compared to just $368 million in 1998, according to Atkins.

"There's still some concern about liquidity," Lonski says. "Some people show preferences for megasized issues.

It tends to work against small- to medium-sized investment grade or high-yield issuers."

Investors believe the greater premium being placed on riskier bonds reflects the still-uncertain outlook for the global economic landscape. But according to Margaret Patel, manager of the $10 million

Third Avenue High Yield

fund, improvement in the global economy should help spreads continue to tighten against Treasuries and allow further acceptance of smaller companies.

"The average size has been trending lower in recent weeks," Atkins says. "Last week $470 million was the average size. The number of deals in the $200 million to $500 million size are increasing, since people are comfortable accepting less liquidity in the assets they hold."

Patel believes the pattern she's witnessed in the last several weeks -- less-recognizable names increasingly attracting financing at lower prices -- will continue. "The market continues week by week to do better, and there's every indication of health and a restoration of confidence," she says.

She thinks investors will continue to slowly accept new names in the market, and the riskiest sectors of the fixed-income arena will eventually resemble the 1995 to 1997 period. But will the market return to the frenzied level of issuance in 1998, when the total volume of new high-yield issuance outpaced 1997 by the end of July? If history is any guide, the market won't know until a crisis has hit.

Paul is less optimistic, and emphatic. "The world's changed," he says. "I would be surprised if this

pattern changed very quickly. The smaller companies are going to have to continue to pay for the illiquidity they represent."