Capital Markets

Damn the Junk Defaults, Full Speed Ahead

Despite warnings that the default rate will soar this year, investors pour cash into the market with growing zeal.
Stephen TaubMay 9, 2008

Investors apparently are more hopeful about the U.S. junk-bond market than the companies that rate the paper.

There was a net inflow of about $612 million for the week ended Wednesday, according to AMG Data Services. That was more than double the $297 million net inflow the previous week and the most in four weeks, Reuters reports.

Investors have now poured money into junk-bond funds for six straight weeks, according to Reuters. The rally comes as fears of a wider collapse in the credit markets have abated. Junk funds were up 4.17 percent in April, says Reuters, citing data from Merrill Lynch. Year-to-date, they are up 1.36 percent.

Despite the surge, Moody’s Investors Service warned on Tuesday that several recent developments point to a sharp increase in defaults among vulnerable issuers of speculative-grade debt. In a new report, the credit-rating company forecast that the U.S. junk-bond default rate will rise to 4 percent at the end of 2008, quadruple the year-end 2007 rate.

Moody’s explained that low-rated issuers face increasing refinancing risk and liquidity pressures. Further, a persistently tight lending environment is narrowing options for these issuers as debt matures and available credit lines dwindle.

However, it is possible that these potential developments are already priced into the paper of the potential defaulters. Indeed, since mid-March, when Bear Stearns collapsed, the spread between junk bonds and Treasuries has narrowed from an incredibly wide 860 basis points.

Meanwhile, mutual funds depend on new cash to buy new issues, and in recent weeks, there has been an uptick in corporate bond underwriting, including junk bonds. Moody’s, of course, was warning about existing, older issues.