Junk bonds take a beating

To put it bluntly, the high-yield bond market has collapsed. There are simply no buyers for this kind of paper right now. Liquidity has completely dried up and new issues have been pulled in the face of total disinterest.

Doug Knight of Vancouver is one of the country’s leading authorities on this type of security. He’s manager some high-yield bond funds and describes the past two months as “absolutely brutal.” He adds: “It’s become so bad there must be an end in sight.”

High-yield bonds, which are more popularly known as junk bonds, are securities issued by corporations with relatively low credit ratings. As a result, they pay a much higher rate of return than government bonds or issues from blue chip companies like banks.

Concern about defaults
There’s at least one main reason the high-yield bond market has taken such a beating. A lot of the issues originate from high-tech companies that had to pay premium interest rates to raise money. With the NASDAQ meltdown, many investors are becoming increasingly concerned about defaults-where companies are unable to meet their interest payments or even to repay principal. This would leave invests holding worthless paper.

That’s always a risk in the high-yield bond market. As a result, there has been a stampede away from tech issues in particular and, in general, from any company that doesn’t have solid, predictable cash flow.

How bad is it?
Knight points out that the high-yield bond index in the U.S. is currently yielding more than 800 basis points (eight percentage points) more than U.S. Treasury bonds. The last time the spread was that great was in September 1991, when the default rate was running at 10.5 per cent. The current default rate is 4 per cent, with Moody’s forecasting 7 per cent for this year.

The spread in Canada is only slightly less. The Merrill Lynch Global High Yield Index currently yields 13.1 per cent, which is 735 basis points over Canada bonds.

What happens next?
It could get worse before it gets better. But Knight believes we’re getting close to bottom. He expects the U.S. Federal Reserve Board to begin lowering interest rates next year, after first shifting to a neutral stance from its present tightening bias. That will start to ease the pressure on the high-yield bond market. As well, he does not see any sign of a recession on the horizon. That would be devastating news for high-yield bonds because it would greatly increase the default risk.

Knight has been doing some homework, looking at what happened the last time spreads reached levels like this. In the year after September 30, 1991, he says the return on the U.S. high-yield bond index was 22.2 per cent. From that date, the annualized rate of return over the next five years was 13.6 per cent.

Buy low believers
Of course, back in 1991 we were just starting to emerge from a deep recession. Today, we appear to be moving into an economic slowdown – not a recession, probably, but certainly decelerating growth. So the climate is somewhat different.

Nonetheless, if you’re a believer in buy low, sell high, then the present situation does appear to present a buying opportunity – if not right away, then in the coming weeks. The high-yield bond market will turn around, as it always has in the past. What we cannot predict with certainty is the timing.

At the very least, if you hold units in a high-yield bond fund, this is not a time to be thinking about selling. We should be at the bottom or close to it. Next year, matters should start to improve.

Adapted from the Internet Wealth Builder, a weekly e-mail newsletter edited and published by Gordon Pape.