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MARKET BEAT

Junk Bonds Shed Their Trashy Image

March 02, 1992|TOM PETRUNO

Rather than buy stocks in this hot market, some money managers believe that they have a much better idea: junk bonds.

Despite the checkered past of these high-risk, high-yield corporate IOUs, their fans say the future should be significantly more rewarding for junk owners.

More rewarding, in particular, than what a lot of stocks may provide in the near term, given their current heights.

If the question is value, "anybody who is willing to invest in common stocks today but is unwilling to invest in junk bonds just isn't being rational," declares Glen King Parker, publisher of the Income & Safety mutual fund newsletter in Ft. Lauderdale, Fla.

The junk bond market crash of 1989 and 1990--sparked by the recession and the subsequent bankruptcies of many debt-burdened companies--was followed by a dramatic rally in junk bond values last year, as hopes soared for an economic recovery.

Yet, even with their '91 comeback, annualized yields on many junk bonds still are very high--from 10% to 14%, generally. Because the majority of companies that issued these securities have never had a problem making interest payments, junk bond bulls say today's yields represent a terrific opportunity for patient, long-term investors. And that should be true no matter what happens next with the economy or interest rates, the bulls say.

Here's why:

* If the economy recovers strongly this year, the profit outlook for junk bond companies will improve as well--which should make their bonds appear less risky to investors. Thus, the potential audience for junk securities should grow in a better economy.

That, in turn, should help offset the negative effect on junk bonds of any rise in market interest rates that accompanies a recovery. Rising rates normally depress the value of existing fixed-rate bonds. But because junk yields now are so high, the bonds are less sensitive to a boost in market rates.

So far this year, for example, an index of junk bonds tracked by Merrill Lynch & Co. has posted a "total return" (interest plus bond price change) of 5.7%. In contrast, Merrill's index of long-term U.S. Treasury bonds has dropped 3.1%.

So rising market interest rates this year have proven deadly to Treasury bonds, but not to junk.

* If the economy just muddles along in a slow recovery, and interest rates stay mostly flat, the stock market will probably continue to attract new investors--if only because of a lack of alternatives. And a healthy stock market is the junk bond market's best friend.

With stock prices at record highs, many companies are issuing new shares to pay off debt. The trend has been especially pronounced among junk companies, many of which are firms that were taken private in leveraged buyout deals in the late 1980s.

As junk bond companies deleverage, they improve their finances and thus improve the margin of safety on any remaining debt they have. "So as long as the stock market does well this year, our market will do well," says Dick Swingle, manager of the $1-billion T. Rowe Price High Yield fund in Baltimore.

* If the economy fails to recover this year, market interest rates are likely to slide anew. For investors who now rely on Treasury bonds for income--and who already are fed up with returns of just 6% to 7% on those securities--a further drop in those yields would make junk bond yields of 10% to 14% even more alluring.

Of course, a weaker economy also could send many more junk bond issuers into bankruptcy. However, a continuing economic slump in 1992 isn't likely to have the same devastating effect on the junk market as did the recession's arrival in 1990, simply because the weakest companies have already gone bust.

"The beauty of leverage is that your mistakes are washed out very quickly" when the economy sours, says Earl McEvoy, manager of the $1.7-billion Vanguard High-Yield Corporate junk fund in Valley Forge, Pa.

There will, however, still be more junk bond defaults--the term used when a company stops paying interest on its bonds. C. Richard Lehmann, who publishes the Defaulted Bonds newsletter in Miami Lakes, Fla., says another $25 billion to $27 billion in junk bonds could default this year. That would add to the $69 billion already in default, out of a junk bond universe of about $370 billion.

But junk default figures have become misleading. For one, many of the companies expected to default are already known, so their bonds long ago plunged in value--such as those of retailer McCrory Corp., which filed for Chapter 11 bankruptcy protection last week.

Also, bankruptcy creates an opportunity for a troubled company to forge a survival plan that can actually lift the value of its depressed junk bonds, by ending the uncertainty surrounding the company. "Prepackaged" bankruptcies are the trend, wherein bondholders and other creditors strike a deal in advance of the actual Chapter 11 filing. "Default by design has become very much in vogue," notes Lehmann.

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