Junk Bonds May Repeat Crash of 2002 on Increasing LBO Credits
By Caroline Salas
May 15 (Bloomberg) -- Never have so many made so much money from junk bonds, and that worries Dan Fuss.
Fuss, whose $10.7 billion Loomis Sayles Bond Fund has been the best performer among its peers the last 10 years, says high- yield, high-risk securities are showing unmistakable signs of a bubble. Yields are near record lows relative to government securities even though sales of the riskiest bonds increased 39 percent from last year, debt has grown faster than earnings and the economy is expanding at the slowest pace in five years.
``I haven't felt this nervous about a market ever,'' said Fuss, vice chairman of Loomis Sayles & Co. in Boston, who's been working in the banking and securities industries since he joined Wauwatosa State Bank in Wisconsin in 1958. His fund has returned an average 9.91 percent a year for the last decade, the best of 45 funds with similar investment rules, according to Lipper, the mutual fund research firm.
Martin Fridson, head of high-yield research firm FridsonVision LLC, and Mariarosa Verde, managing director of credit market research at Fitch Ratings, say sales of junk bonds and the record $366 billion of leveraged buyouts may lead to the worst bear market for bondholders.
The last time junk bonds tumbled was in 2002, when companies defaulted on $166 billion of their securities, according to Moody's Investors Service. Merrill Lynch & Co.'s High Yield Master II Index fell about 2 percent that year as yields on the securities rose to a record 11.2 percentage points over Treasuries. Speculative grade, or junk, bonds are rated below Baa3 by Moody's and BBB- by Standard & Poor's.
Severe Downside
``The downside is likely to be very severe,'' Fridson, who led Merrill's high-yield strategy group until he left in 2003 to start his own firm, said in an interview from his office in New York.
Fridson predicts that in the next few years the default rate may reach or surpass the 2002 level, when WorldCom Inc. in Jackson, Mississippi, and Adelphia Communications Corp., then based in Coudersport, Pennsylvania, filed for bankruptcy.
About 1.5 percent of junk-rated companies have defaulted on their debt this year, near the lowest in a decade, Moody's says.
``Defaults are almost non-existent today and, well, we know that doesn't hold forever,'' said Thomas Lee, who stepped down last year from Thomas H. Lee Partners LP, the Boston-based takeover firm he founded 32 years ago.
``When the economy goes bad, defaults will spike up from 1 percent into the 9 percent level,'' Lee said at the Milken Institute Global Conference in Los Angeles on April 25. ``If that happens then the financing part grinds to a halt'' for LBOs, he said.
`Fantasy Land'
More than half of the junk bonds sold this year were used to pay for leveraged buyouts and mergers and acquisitions, according to Barclays Capital. Money is so easy to come by that for the first time some investors agreed to let borrowers choose to make interest payments in cash or in additional bonds.
``This is fantasy land for corporate treasurers,'' said Edward Altman, a professor of finance at New York University's Stern School of Business. Altman in 1968 created the Z-score, a mathematical formula that measures a company's bankruptcy risk. They ``are smiling like Cheshire cats'' and borrowing conditions ``entice them to increase their leverage.''
Univision Communications Inc., the Los Angeles-based Spanish-language broadcaster, and real estate broker Realogy Corp. of Parsippany, New Jersey, financed their takeovers in part with so-called toggle bonds that give the issuer the option to pay interest with more bonds.
Univision, Realogy
Univision sold $1.5 billion of toggle notes on March 1 that are rated B3 by Moody's and CCC+ by S&P. The notes pay cash interest of 9.75 percent and a pay-in-kind coupon rate of 10.5 percent.
Realogy sold $550 million of the securities on April 5 with an 11 percent cash coupon and an 11.75 percent rate if paid in extra notes. They are rated Caa1 by Moody's and B- by S&P.
Stephanie Pillersdorf, a Univision spokeswoman, and Mark Panus, a Realogy spokesman, didn't return calls for comment.
The growth of toggle bonds is a symptom of too-easy credit, Fridson said. Giving companies the ability to pay interest with more debt rather than cash shows they ``have a reasonable likelihood of needing to exercise that option,'' he said.
There have been 10 sales of toggle bonds this year, amounting to $5.14 billion, the most ever, according to S&P's Leveraged Commentary and Data unit. There were five sales totaling $4.05 billion completed in November and December of last year. Before that, only luxury retailer Neiman Marcus Group had issued the securities, in September 2005.
A Losing Game
Federated Investors Inc. has been buying toggle bonds to boost returns, said Mark Durbiano, who manages $3.5 billion in junk bonds from Pittsburgh.
``If we like the issuer, we're not afraid of buying the toggles to get a little more return for the same level of fundamental risk,'' said Durbiano, adding that the firm has been investing in pay-in-kind notes for 20 years.
Betting against corporate bonds has been a losing game. The debt has returned 4.47 percent this year, Merrill data show. U.S. Treasury bonds have gained 1.80 percent and corporate bonds with investment-grade ratings have returned 2.21 percent in the same period, Merrill data show.
Investors get an extra 2.63 percentage points in yield on average to own junk bonds rather than Treasuries, down from 3.73 percentage points at the start of 2005 and more than 10 percentage points in 2002, according to Merrill data.
No `Catalyst'
JPMorgan Chase & Co. analyst Peter Acciavatti, the top- ranked high-yield analyst in Institutional Investor magazine's annual poll the past four years, lowered his default forecast for the end of this year to 1.25 percent from 2 percent on a dollar-weighted basis, in part because issuers have taken advantage of low rates to refinance and extend maturities.
``Companies just don't have payments they need to worry about for the next couple of years,'' Acciavatti said in New York. ``It all goes back to the liquidity we're seeing. I don't see the catalyst for rising defaults except for the economy. If the economy gets worse from here it will eventually start to have a toll on earnings and leverage.''
The average B rated company borrows at a yield premium of 2.61 percentage points above Treasuries, near the lowest since 1997 and about one percentage point less than it cost BBB rated companies to borrow at the end of 2002, according to Merrill.
Fuss, 73, said the likelihood of losses has prompted his Loomis Sayles fund to invest in longer-maturity Treasuries while he waits for the yield spread between corporate and government bonds to increase.
Franklin's Strategy
More than 18 percent of the securities sold this year were rated CCC or lower in the first quarter, up from about 15 percent last year, according to Fitch. The securities comprise about 18 percent of the $675 billion Merrill high-yield index, more than double the proportion from 10 years ago.
``Many believe that this is indicative of a default cycle that will be equal to or greater than the default rates during 2000 to '02,'' Alexander Chan, an analyst at Barclays in New York, said in a report this month.
Franklin Resources Inc., which manages more than $120 billion in fixed-income, has been ``significantly'' paring its investments in CCC bonds over the past 18 months, said Eric Takaha, director of high-yield at the San Mateo, California- based firm. The average bond in Franklin's high-yield portfolios is rated a ``mid-to-high'' B, up from a ``mid-to-low'' B during the same time period, he said.
Risks Building
``You don't want to ignore the quality of new issuance,'' Takaha said. ``You have to be watchful if the economy doesn't just slow but actually turns down.''
The economy may grow 2.1 percent in 2007, the slowest in five years, according to the median of 65 estimates in a Bloomberg survey taken from April 30 to May 8.
Companies are piling on debt even as the economy slows. The total debt for about 300 companies rated BB and B expanded by 16 percent last year, double its growth in 2005, according to Fitch.
Debt strategists at New York-based Morgan Stanley, the world's second-biggest securities firm, calculated in a report last month that leverage is rising for eight of the 15 high- yield industries it covers, the first ``meaningful'' increase since 2002.
Ford Motor Co. lost $282 million in the first quarter and is $23 billion deeper in debt than it was a year ago. The Dearborn, Michigan-based company's $3.7 billion of 7.45 percent bonds due in 2031 trade at a yield premium of 4.63 percentage points, down from 5.38 a year ago, according to Trace, the bond- price reporting system of the NASD. Ford is rated Caa1 by Moody's.
Recovery Rates
Credit quality ``is moving in a less desirable direction,'' said Fitch's Verde, who is based in New York.
Bond investors should also worry because companies are adding more senior secured loans, which rank ahead of junk bonds in a bankruptcy, Verde said. A record $686 billion of high-yield loans were made last year, Bloomberg data show.
The average recovery rate for unsecured bonds may fall by as much as 10 percent from its historical average of 40 cents on the dollar because of the rise in loans, according to Fitch.
``Structural risks are rising,'' Fitch's Verde said. ``They're simply being masked by the low default rate.''
More than $108 billion of so-called covenant-lite loans, or those that don't hold borrowers to limits on quarterly debt, have been completed this year, compared with a total of $36 billion in the previous 10 years, according to S&P's LCD.
``The normal thing is two to four years after the issuance for defaults,'' said NYU's Altman. ``Deals with little covenants, toggles, push back the timeline. But it's gotta happen.''
To contact the reporter on this story: Caroline Salas in New York at
[email protected]
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