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Demand Climbing for Junk Bonds

Yields on the risky securities have fallen but are still seen as attractive and indicate confidence in economic recovery.

October 24, 2003|Tom Petruno | Times Staff Writer

In a vote of confidence on the economy's outlook, investors in recent days have driven corporate junk bond interest rates to their lowest levels since the modern high-yield bond market was born in the late 1970s.

The hunger for "junk" securities -- so named because they are rated below investment grade in quality -- shows that investors believe the economy will continue to expand next year, analysts say, lifting the fortunes of many indebted companies and boosting their ability to repay creditors.

The demand for the bonds also reflects dissatisfaction with other investment options, including Treasury securities and perhaps stocks, some say.

The annualized yield on an index of 100 junk bonds tracked by KDP Investment Advisors fell below 8% last week for the first time since the index was created in 1990. As of Wednesday, the yield stood at 7.92%, compared with 10.77% at the start of this year.

Bond yields move in the opposite direction of prices: As investors bid aggressively for bonds, the securities' prices rise and yields fall.

The yield on a Merrill Lynch & Co. junk bond index that dates to 1984 also has fallen to about 8% this week, its lowest level ever, the brokerage said.

Kingman Penniman, head of high-yield bond research at Montpelier, Vt.-based KDP, said there had been a sense in the market in recent weeks that some big investors were desperate to own more junk securities, given the optimistic outlook for the economy in 2004.

"I think we're seeing institutional money that believes it needs to get into high-yield bonds by the end of the year," Penniman said.

Daniel Fuss, a veteran bond fund manager at Loomis Sayles & Co. in Boston, said many pension funds, in particular, were looking to junk bonds to help raise their overall portfolio returns.

Many pension funds need annualized returns of 8% or more in the next decade to meet their financial obligations to retirees, experts note. With Treasury bond yields still relatively low, and the stock market's future returns more uncertain after this year's strong run-up in share prices, options for earning 8% or better may have dwindled, Fuss said.

"If you're assuming you're going to earn 8.5%, well, wonderful -- how are you going to do it?" Fuss asked.

Of course, high-yield corporate bonds are no slam-dunk. They bear rich interest returns precisely because the securities are far riskier than higher-quality bonds. Over the last 20 years, many junk-issuing companies have gone belly up, costing their bondholders dearly.

But the junk market may now be in a sweet spot, some experts say: An improving economy should further reduce the risk of failure among junk firms.

At the same time, yields on the bonds still are well above returns on Treasury bonds, which means that even if Treasury yields continue to rise, junk yields may fall further or rise relatively little.

That has been the pattern since mid-June. The yield on the 10-year Treasury note, a benchmark for other long-term interest rates, has soared from a generational low of 3.11% on June 13 to about 4.32% now, as investors have bet that the accelerating economy eventually would drive up interest rates in general.

In the same period, the yield on the KDP junk bond index has declined. It stood at 8.55% on June 13.

Junk bond investors have been cheered by a continuing slide in the securities' overall default rate -- meaning the number of companies that have become unable to make interest or principal payments because of financial trouble is declining.

Worldwide, 5.7% of junk bond issuers went into default in the 12 months ended in September, according to bond credit-rating firm Moody's Investors Service in New York. That annualized rate has been sliding from its peak of 10.8% in January 2002, said David Hamilton, director of corporate default research at Moody's.

Hamilton projects that the default rate for the universe of about $500 billion in junk bonds will be below 4% one year from now, if the economic recovery continues.

Just as millions of American homeowners have improved their financial lot by refinancing their mortgages, many junk-issuing companies also have refinanced older, higher-cost debt over the last two years, giving themselves more financial breathing room and thus boosting their image with investors.

Irvine-based home builder Standard Pacific Corp., for example, sold $150 million of junk bonds Sept. 23 at an interest rate of 6.5%. The money was used to pay off bonds that were costing the firm 8.5% a year in interest.

One measure of the relative attractiveness of junk bonds is the difference between junk yields and the 10-year T-note yield -- the so-called interest rate spread.

Using the KDP index, that spread is about 3.6 percentage points. Over the last 10 years, the median spread has been about 4 percentage points, Penniman said. It was about 3 points early in 1994.

Junk bonds were more attractive when yields were higher at the start of this year, but at the current spread "this isn't the worst value we've ever seen in high yield," Penniman said.

But he and Fuss caution investors not to expect in 2004 the kind of capital appreciation the bonds have produced this year as market yields have fallen. The average junk bond mutual fund's total return in the first nine months of this year -- interest earnings plus capital appreciation -- was 17.4%, according to fund tracker Morningstar Inc.

For the next five years or so, Fuss said, investors in a diversified portfolio of junk bonds should expect returns amounting to what they get in interest payments, and perhaps a percentage point or two in net capital appreciation each year.

If he's right, Fuss said, that may mean junk returns would be very competitive with what the stock market might produce.

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