Junk Bond Defaults on the Rise

HIGH-RISK INVESTMENTS

By , Staff writer of The Christian Science Monitor

INVESTORS are watching the junk market with particular care these days. And for good reason. A sustained rally is not generally expected for the junk bond market anytime soon, despite a flurry of tentative rallies this year. Moreover, a protracted or deep recession could mean the default of outstanding junk bond issues worth billions of dollars.

The stakes are high. Many of the bonds were issued by leading American corporations employing hundreds of thousands of workers. And they are held not only by individuals but also by banks and large institutional investors, such as insurance companies and pension funds. Cash-strapped companies

Already this year, some $16 billion worth of corporate bonds have defaulted, largely the result of declining corporate profits and a slowing United States economy. Much of that loss represented bonds that were first issued at corporate grade level (BBB or better), yet were subsequently downgraded to junk status, says George Weinfurtner, an advisor to the Bond Investors Association Inc. The BIA is a nonprofit bondholder-supported organization based in Miami.

Recommended: Default

The BIA estimates that corporate defaults could reach $23 billion in 1990 and $69 billion for the 1990-1992 period. But if there were to be a deep recession, the numbers could be much bleaker, perhaps up to $100 billion for that period.

According to Richard Lehmann, president of the BIA, the current default rate on junk bonds is running at around 7 percent. That represents a sharp rise from the more typical 1.5 percent to 2.5 percent default rate in recent years, he notes. For 1988 and 1989, total defaults reached roughly $17 billion.

Junk bonds are high-yield, high-risk bonds issued by relatively young companies, or bonds issued by well-known companies that have difficulty getting an investment-grade rating. Junk bonds rode into popularity in the middle to late 1980s as a way of financing corporate buyouts and takeovers. Investors can purchase the bonds individually, or by buying into high-yield junk bond mutual funds.

Junk bonds mutual funds took a beating late last year and during the first quarter of this year when the number of defaults began to rise, and investors started to flee junk for less risky instruments. Still, there have been a number of tentative rallies in junk issues this year, says Lori Lucas, a junk bond analyst for Morningstar Inc., a Chicago-based research firm.

Brief rallies, Ms. Lucas says, occurred in March, June, and July, in each case underscored by some cash inflows back into junk bond mutual funds. And junk bond prices rallied somewhat early this month, experts note.

So far this year, redemptions add up to $3 billion for the 41 junk bond funds followed by Morningstar. Assets in those junk bond funds are now near $22 billion, compared to $25 billion in 1989, and $30 billion in 1988.

Both managers of junk bond mutual funds and their investors are seeking to improve their strategic positions in case of a less-than-mild recession, Lucas says.

A number of junk funds, she says, have altered management teams, and fund objectives are changing somewhat to soften reliance on high-risk issues. Thus, some funds are becoming more like equity funds; others are becoming more like higher-grade corporate bond funds.

For example, a number of junk bond funds, Lucas says, are now seeking to emphasize not just high yield but income and capital appreciation. That is done, she says, by buying better grade corporate issues or high-yield equities.

Mass exodus unlikely

Lucas notes that junk bond mutual fund issues, for all their bad publicity of late, have not been performing that badly in comparison to alternative investments, such as equity funds. Thus, even if the economy were to worsen substantially, she does not anticipate a mass exodus from junk bond funds. The least-sophisticated junk bond fund investors, she says, have probably already left the market.

In the case of junk funds, diversification provides a strong safety hedge. That safety margin is not typically as great when junk bonds are individually held.

The US life insurance industry alone owns some $60 billion of the $200 billion of outstanding junk bonds in the US, according to a report by IDS Financial Services in Minneapolis. Junk bonds account for 6.4 percent of total invested assets of the life insurance industry. But the total capital of the industry is only about 6.5 percent of assets. That means that junk bond holdings for the life insurers equals their capital, according to IDS.

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