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A Place for the Junk : New Corporate Bond Trading System to Be Launched

April 21, 1993|KATHY M. KRISTOF

High-yield junk bonds--already one of the hottest investments of the 1990s--may soon get even hotter.

A soon-to-be-implemented trading system could ease buying and selling of these corporate bonds, which pay higher yields because of their higher risk. The system, which will work much like the highly automated NASDAQ stock market, will make it easier to buy and sell junk bonds, industry experts contend. That could help boost junk bond prices.

"The trading system is going to give much higher visibility and liquidity to these bonds," says C. Richard Lehman, editor of the High Yield Securities Journal, a junk bond newsletter published in Miami Lakes, Fla. "It will have a significant effect."

The National Assn. of Securities Dealers, which operates the NASDAQ system, says it will launch the new trading system this fall. The system will initially list 35 to 50 "actively traded" high-yield bonds. The NASD says it could delist bonds that suddenly become inactive, but it expects to add rather than subtract bonds as time goes on.

The trading system will not materially change the way business is done, says Bill Broka, vice president of trading and market services at the NASD. The bonds will continue to be purchased and sold through brokers, just like Treasury securities and municipal bonds.

However, once the system is inaugurated, brokers will be required to report the trading prices of specific bonds each day. Those trading prices will be available to the general public, possibly through newspaper listings, as with prices of exchange-listed stocks and bonds.

That's a significant change in the high-yield market, where prices for some issues are virtually impossible to ascertain quickly. Although it's easy to get a quote for a handful of actively traded, high-profile bonds, other bonds are sold primarily through one or two dealers. As a consequence, those who don't know the right dealer to call may not be able to buy particular securities.

Some believe the lack of an efficient market also affects prices of the bonds, depressing those of some issues and boosting others'.

Although the developing NASD system is not likely to solve all the junk market's woes--it can't, for example, make junk issuers more credit-worthy--it should ease trading and, to some degree, stabilize trading prices.

Many of the details have yet to be worked out. NASD officials say they don't even know exactly how many or which bonds will be listed in the first days of trading.

Few believe that the trading system will change how individual investors buy these bonds. Individuals mainly participate in the junk bond market through mutual funds. Mutual funds, which pool the money of many investors, are an ideal way to buy these bonds because they give small investors the ability to get a diversified portfolio for less than a fortune.

Still, the system is expected to make trading easier for wealthy individuals as well as for smaller mutual fund companies and other institutional investors. And that's got many experts saying this might be a good time to jump into junk.

"If you create a market system and have daily quotations, you are going to bring more buyers in," Lehman says. "And when these people can look at the prices each day, it will give them more confidence."

That should boost returns, he says.

Returns are already generous in the junk bond market. At a time when 10-year Treasuries are yielding less than 6%, junk bonds with similar maturities pay between 7.5% and 14%, depending on how risky the issue is.

For the 12-month period ended March 31, the average yield on mutual funds investing in high-yield bonds was 9.9%--more than any other type of bond fund, according to Lipper Analytical Services in New York. Average total return--which includes yield as well as increases or decreases in bond prices--was 15.74% for that period, according to Lipper.

You do, of course, accept greater risks for that higher yield. Companies issuing these bonds are usually deeply indebted and less able to pay their bills than the issuers of high-quality bonds. As a result, there's a greater risk of default.

High-yield bonds are also subject to greater price swings than higher-quality bonds such as Treasuries because skittish investors are likely to bail out of junk at the first hint of trouble.

How much extra default risk you're taking on is debatable. But depending on whose statistics you use, there could be a 1.5% to 10% chance that the average junk bond issuer will default. (The difference is partly explained by the fact that not everyone agrees on the definition of "junk.")

Still, nearly everyone agrees that the risks have diminished in recent years. That's because junk bond issuers have paid off or refinanced a significant amount of their debts in the last two years. Now they're much better able to pay, experts say.

"Credit quality is dramatically better today," says Marko Budgyk, managing director at Houlihan, Lokey, Howard & Zukin, an investment firm in Los Angeles.

Lehman says he expects defaults to fall to about $5 billion this year--the smallest total since 1988. That compares to $7.57 billion in defaults during 1992 and a whopping $23.34 billion in 1991. Defaults peaked at $28.5 billion in 1990.

Given borrowers' improved credit quality, some experts believe that today's yields are exceptionally generous. Junk bond investors are getting premium prices, they add, mainly for two reasons: People got spooked when the junk bond market crashed in 1989 and 1990, and they remain concerned about the market's volatility. Second, price information remains difficult to get because many of the issues are traded infrequently--a problem the new system will address.

Less Junky:

With an improving economy, junk bonds are better credit risks today than they were in the past, experts say. The proof is in declining junk bond defaults.

In billions

Junk bond defaults:

1988: $5.03 billion

1990: $28.53 billion

1992: $7.57 billion Source: Bond Investors Assn.

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