CREDIT CRUNCH: When Will Junk Return?

What the junk bond market needs to happen before issuers can come back.
Ed ZwirnJanuary 12, 2001

The optimism prompted by the recent Fed rate cut gave an immediate boost to less speculative investments. Will the rest of the market soon follow in lock step?

Both junk bonds and initial public offerings slowed to a trickle late last year, cramping the ability of many new or otherwise struggling firms to raise money.

However, more than $61 billion of non- governmental debt has hit U.S. markets in the eight business days since the start of the new year.

Not surprisingly, the bulk of this activity has occurred since the Fed move.

But does this mean that America’s risk-taking penchant has made a sudden return?

Not quite. As yet, some 94 percent of this year’s tally has been either investment-grade or agency issuance.

And, so far this year, even the high yield bonds issued have been concentrated exclusively in the “B” ratings area. Firms such as Charter Communications and McLeodUSA, which sold a combined $2.5 billion on Jan. 5, may be speculative but their debt can hardly be called junk.

In addition, the relatively large sizes of these issues should serve to make them more liquid on secondary markets.

Size Counts

“You’re not going to see $70 million triple-C- rated issuers,” Martin Fridson, chief high- yield strategist for Merrill Lynch, told a recent session of the New York Capital Roundtable.

Or, for that matter, a “triple-C issuer looking to do a $100 million first time deal,” he said. “The market is just not open to that kind of deal at this time.”

And won’t be any time in the very near future, Fridson predicted.

“If the country is still sliding into a recession, you’re not going to turn it around on a dime just by lowering rates,” he tells

But despite the short-term reasons for pessimism, Fridson remains optimistic about the more speculative end of the market, and argues there is ample reason for predicting an eventual turnaround.

First, A History Lesson

It wasn’t until the 1970s that there was much debt worth mentioning issued on the corporate bond market rated below triple-B, or below investment-grade. It wasn’t until 1977 that issuance of this debt even reached the $1 billion mark.

By 1998, according to Fridson, issuance of more speculative debt had reached an all-time high of $140 billion. Y2k saw that annual total dwindle to about $50 billion.

What happened in between?

It began overseas with the meltdown of Russian debt in late 1998, and culminated later in the year with the collapse of hedge fund Long Term Capital Management. The losses incurred by the debacle surrounding that hugely leveraged fund frightened the market.

It was at this point that many of the key underwriters of corporate debt began to back off.

Many of these players quietly decided that backing the great variety of all sizes and caliber of corporate bond issuance available at that time just entailed too much risk.

In the case of the smaller, more marginal quality paper, dealers began holding back because they were “not going to buy back the whole issue and no other dealer [was] going to make a market in it.”

In the meantime, as everybody now recognizes, defaults were headed upward as the result of a great amount of low quality debt issuance. These defaults are still on the rise, having come in at greater than 6 percent last year, and probably reaching 9 percent in 2001, according to Moody’s Investors Service.

And this will be the case even if the economy does not go into a tailspin this year.

Fridson argues that current yield levels justify a “default rate of 13 percent.”

And the default numbers are likely to pick up even if you predict moderate growth. “At 1.5 percent to 2 percent real [economic] growth, you start to see defaults pick up,” he says.

Tech Meltdown Intervenes

But even the increasing default levels experienced recently might not have caused the market to reach the depths into which it has descended were it not for another interposing event: Last year’s tech meltdown.

The tech meltdown of Y2k did two things to the high-yield market. First of all, it obviously frightened off many “mom and pop junk investors” and started a pronounced outflow in the mutual funds dedicated to that type of investment. November and December saw constant outflows from these funds, the most pronounced and prolonged withdrawal of funds from the high-yield market since the sector was born.

In addition, the demise, while perhaps temporary, of other funding options such as IPOs and venture capital have had the unwelcome effect of crowding and revealing the weaknesses of an already weakened market.

Hopeful Signals

While nobody seems to be predicting a full- blown resurgence of opportunities to issue high-yield debt in the immediate future, Fridson does see some hopeful indicators already surfacing. But he notes that there are other necessary developments that have yet to happen.

Mutual fund outflows notwithstanding, Fridson argues that these funds probably have more cash on the ready for investment than any time in their histories.

They are, after all, the prime investors in high yield bonds, and they have been clipping coupons on the debt they hold, which is still overwhelmingly solvent.

These funds as of the end of November held at least 7.9 percent of their money in cash equivalents, according to the Investment Company Institute. Fridson deems this estimate to be “understated,” given his argument that high-yield bonds which are past their call date but yielding higher than market levels should be considered cash, since they are likely to soon turn into cash.

“Some of these bonds might have five years left until maturity but the company will almost certainly redeem them,” he said.

In addition, Fridson thinks that when the figures come out, the first two weeks of 2001 will almost certainly exhibit a reversal of the mutual fund outflow trend for high-yield bonds.

What to Wait For

But the recovery is far from being a done deal.

Fridson, as well as market participants and analysts from both Moody’s and Standard & Poor’s, expect further rate cuts by the Fed. And the cuts must happen at regular Federal Open Market Committee meetings for them to prove reassuring to investors.

“The [Jan. 3] rate cut, occurring between meetings and being larger than the usual 25 basis points, gave rise to all sorts of speculation concerning the reasoning behind it, including the situation of California’s electric utilities, Fridson notes.

An even more unsettling aspect of the surprise Fed rate cut, he adds, has been the widespread perception that “maybe the economic numbers that the Fed has and [the numbers] we don’t [have] are worse than we thought.”

In addition, a letup in the current climate of economic uncertainty is needed in order to restore the proper shape of the yield curve. The slope of the Treasury curve from 90 days to 10 years is currently negative, meaning that an investor can get a greater yield on a three-month bill than on a 10-year note.

While this downward slope has amounted to as much as 40 or 50 basis points in recent weeks, don’t expect any significant progress until a 10-year Treasury yields about 100 basis points higher than a 90-day instrument.

Says Fridson, “This is one of the leading indicators of the economy.”