Would Recession Hurt Junk Bonds?

INVESTMENTS

IF any single economic circumstance could send the junk-bond industry into disarray, it can be summed up in one word: recession. The $190 billion junk-bond market in the United States has, of course, seen its share of economic downturns in recent years, such as recessions in the early and mid-1980s. And in each case, the junk market eventually emerged relatively intact, rising to new sales heights.

Nor, apparently, have junk bonds been unduly affected by the legal difficulties surrounding junk-bond titan Michael Milken - or Mr. Milken's late employer, the investment house of Drexel Burnham Lambert. But what makes junk-bond holders especially anxious about the present uncertain direction of the US economy is a confluence of factors:

Perhaps as much as 90 percent of currently outstanding junk bonds were issued by companies after the end of the 1981-82 downturn and in many cases after the 1984-85 slump, according to Perrin H. Long Jr., an analyst with Lipper Securities Corporation. Little wonder, he says, that in ``a period of rising inflation coupled with possible recession there will be considerable nervousness'' about such bonds.

Many of the companies issuing the new junk bonds are significantly leveraged, in terms of outstanding debt. Companies that issue junk bonds - bonds with low credit ratings - are companies that for one reason or other have difficult cash or asset allocations to begin with. But what is unique now is that many of the junk-bond issuers are companies that have been involved in an extensive merger situation or a costly consolidation. In some cases, assets have been exchanged for corporate debt just to finance the mergers. That means that if the companies were to be hard hit by recession, they could have a difficult time selling off assets to raise cash to meet interest payments on the junk bonds, were that to be necessary.

Several junk-bond issuers have had to refinance and restructure their bonds in recent weeks because of internal corporate financial difficulties.

Not all analysts, however, believe a downturn would necessarily spell doom for junk bonds. A study released this week by DRI/ McGraw-Hill, a consulting firm in Lexington, Mass., says that the default rate of junk bonds would be low during the next five years, even if there were a recession. The study concludes that defaults would be around 13 percent from 1989 through 1993 were there to be moderate growth or a recession. That rate would climb to 19 percent under a severe recession accompanied by high inflation and interest rates. The study concludes that junk bonds continue to be very attractive over time.

Junk bonds are bonds that have a low investment grade, compared to investment grade corporate bonds, or US government bonds. To sell such bonds, the issuing company promises to pay a special premium, or particularly high rate of interest.

``The spread [between junk bonds and US Treasury securities or quality-grade corporate bonds] has widened relative to whatever measure you want to use,'' says Mr. Long. Currently, the spread is running between 4.5 percent and 5 percent. The last time spreads were this high was after the stock market crash in late 1987.

Junk bonds, by definition, are risky. That is precisely why they are sold at an interest-rate premium. For normal investors near retirement, they can be tricky.

``For anyone close to retirement, putting all your assets into junk bonds would make it extremely tough to sleep at night,'' says Matthew Turner, an analyst with Donoghue's Moneyletter, published in Holliston, Mass.

About these ads
Sponsored Content by LockerDome

We want to hear, did we miss an angle we should have covered? Should we come back to this topic? Or just give us a rating for this story. We want to hear from you.

Loading...

Loading...

Loading...

Save for later

Save
Cancel

Saved ( of items)

This item has been saved to read later from any device.
Access saved items through your user name at the top of the page.

View Saved Items

OK

Failed to save

You reached the limit of 20 saved items.
Please visit following link to manage you saved items.

View Saved Items

OK

Failed to save

You have already saved this item.

View Saved Items

OK