High-Yield Bond Troubles May Just Be Start

[HenryTo]

Precisely what we mentioned in our mid-week commentary more than two weeks ago: http://www.marketthoughts.com/z20050414.html

However, I agree that only a pullback is probable as well. We will keep our subscribers posted on this and how this situation will affect the stock market going forward.

-------------------------------------------------------------------

High-Yield Bond Troubles May Just Be Start
Thursday April 28, 10:33 pm ET
By Ellen Simon, AP Business Writer
High-Yield Bond Market's Troubles May Be Harbinger of Rough Days to Come for Economy


NEW YORK (AP) -- Hard times for high-yield bonds may presage more rough days for stock markets and the economy.
Investors typically demand higher returns on high-yield debt, commonly referred to as junk bonds, to compensate for the risk that the issuers could go broke and not pay them back. That's why bond rating agencies term them "below investment grade" securities.

But in recent years default rates have been low and institutions and individual investors in search of higher payouts have snapped up billions of dollars worth of these bonds or mutual funds that specialize in them. Among the companies whose debt trades as junk are Qwest Communications International Inc., Nextel Communications Inc. and El Paso Corp.

Now investors are backing away from junk bonds as the economy shows signs of slowing and the Federal Reserve keeps bumping up interest rates. Almost $1.5 billion in high-yield bond offerings were postponed last week, some leveraged buyout deals could be in trouble, and mutual fund investors are starting to cash out of high-yield bond funds.

"Historically, the debt market, especially the high-yield market, has frequently served as an early warning signal for broader weakness in the capital markets," said Duncan Yin, a research analyst at CRT Capital Group, a Stamford, Conn.-based broker-dealer specializing in distressed securities.

Many of the factors causing the junk bond market to cool are unique to it.

For instance, analysts are forecasting that General Motors Corp., which is rated one notch above junk by the three largest bond ratings agencies, will be downgraded to junk status sometime this summer, said Brian Arsenault, the high-yield strategist for Morgan Stanley.

They expect Ford Motor Co. to stay investment grade until 2006, but after that, its debt may be junk, too, Arsenault said.

The fear is that those downgrades will mean the junk-bond category will be awash with new debt. The total value of junk securities is about $900 billion, Arsenault said. GM's rated debt, which doesn't include the car loans its financing arm makes to customers, total $200 billion, according to Standard & Poor's.

The volume of GM debt has investors worried that some institutions, including insurance companies and state pension funds, would be forced to unload their GM bonds because of rules requiring them to only hold investment-grade securities.

But Martin Fridson, publisher of the weekly "Leverage World" newsletter, said he surveyed some of the nation's largest public and private pension plan sponsors, who said their bond managers were not subject to rules requiring the immediate sale-- or sale at all-- of junk bonds.

"Investors are overstating the potential impact of a GM downgrade," he wrote in the newsletter. "Fears of the high-yield market being crushed by new supply of fallen angel debt are not justified."

Other factors affecting the high-yield market are the same as fears roiling stock markets in recent weeks: The fear of inflation and anticipated interest-rate increases, which make sitting on cash look more attractive.

The change in the economic outlook follows a period when conditions in the junk bond market were close to ideal: Stocks weren't too volatile and interest rates were low. During the second half of 2004 and the beginning of 2005, "virtually any deal could get done, the market was not discriminating," Yin said.

That's changed.

Three deals worth almost $1.5 billion, for junk bonds from Cheniere Energy Inc., Diamon Inc. and Hughes Network Systems were all postponed last week, Fridson said.

Banks trying to sell high-yield debt also are finding fewer buyers. "A $3 million deal might get done, while a $3 billion deal might not get done because there aren't enough players," Fridson said.

Mutual fund investors are also getting nervous. They've pulled $1 billion out of high-yield bond funds in the last 10 days, while the total outflow for all bond funds was $1.3 billion, said Charles Biderman, president of Trim Tabs Investment Research, which tracks the flow of money in and out of the stock market and mutual funds.

Investors aren't leaving because they were losing a dramatic amount of money. Junk-bond funds declined only 1.3 percent in value, on average, in the last two weeks, said Biderman.

Some investors believe junk bonds don't deserve the bad time they're having. The total number of junk bond defaults in the first quarter was the lowest in any quarter since the fourth quarter of 1997, according to a Standard & Poor's report, which predicted that more bonds would default in the second half of 2005.

The operating earnings and liquidity for companies whose debt is rated junk continues to look good, said Eric Takaha, director of high-yield bonds for Franklin Advisors.

While junk bonds can be a leading indicator, he said, bad times for junk don't always reflect on the wider economy.

"Even in the 1990s, when high yield had a good run, you would have periods of pullback," Takaha said. "You don't want to factor that out."