Junk Bonds: A Rickety Recovery

Disappointing economic data are giving investors more pause about the timing of a rebound, which could spark less appetite for high-risk assets

By David Bogoslaw

It could be partly the summer heat, but investors' appetite for risk has begun to shrink since a more sober outlook on the pace of economic recovery has taken hold in recent weeks. And that could put the recent recovery of the high-yield debt market on hold.

In a July 7 report, Standard & Poor's Global Fixed Income Research said that the narrowing of the yield spread between high-yield corporate bonds and U.S. Treasury bonds of comparable maturity is likely to take a breather while investors await signals from economic data and second-quarter earnings that will either reignite or discourage demand for speculative-grade debt.

Standard & Poor's said the risk premium in the high-yield market had shrunk at an unprecedented rate over the past six months, with the spread of S&P's speculative-grade composite index dropping to 9.71 percentage points over Treasuries on July 1 from 16.47 percentage points at the end of 2008. The average yield for June issues was about 10.5%, according to S&P, still high but lower than new issue yields in the first quarter. And with default rate expectations still high, "investors may need to see a material improvement in both profits and economic data before spreads undergo another round of significant tightening," S&P said. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Cos. (MHP).)

The default rate on high-yield bonds hit 9.2% in June and, given expectations of a significant number of defaults over the next three quarters, that rate could reach 14.3% by March 2010, the S&P report said. The pool of companies that face substantial default risk is large, with 142 speculative-grade companies, or 13%, rated CCC+ or lower, and an additional 163 companies, or 15%, rated B-, S&P said.

There was a total of $33.5 billion in high-yield debt issued into the market in the prior two months, with the $15.5 billion sold in June evenly split between bonds with BB and B ratings, S&P said. The agency has downgraded 438 speculative-grade companies so far this year, while upgrading just 40 companies. The media and entertainment sector had the largest number of downgrades, 120, and only seven upgrades, while forest products and building materials had 43 downgrades.

A Spooky Unemployment Report

Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass., thinks the high-yield market has reached another inflection point and that investors will wait for more information about the prospects for economic recovery before buying additional speculative-grade corporate debt.

"The [June] employment data kind of spooked people. It brought to light that things may take a lot longer than the market currently expects to recover," which would be problematic for the corporate debt market, he says.

Although the credit market has made great strides to facilitate companies' liquidity needs, parts of it remain closed or aren't functioning properly, says Larkin. The concern is it's still early in the default cycle, and the longer the recovery takes, the greater the possibility that companies trying to refinance maturing debt may be locked out of the marketplace. That would likely cause high-yield spreads to widen again.

Investors who haven't backed away from risk are benefiting from the broader change in sentiment since it keeps the yield spread from narrowing further, giving them an extra 10.5% return above comparable Treasuries, he says. The 50% pullback from the peak spreads last fall may mean high-yield debt is now priced at fair value, given the information about the economy currently available.

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