By a number of measures, junk bonds are having their worst year in a decade, as the bankruptcies of WorldCom, Adelphia Communica-tions and a host of other companies have driven many risk-averse investors away from the sector.
But for those who can accept substantial risk, junk bonds -- more formally known as high-yield bonds -- could deliver formidable returns in the next 12 months, say some economists, fund managers and credit analysts.
"At some point, the junk-bond sector is going to turn, and it is going to turn very positively," said Edward I. Altman, a finance professor at New York University's Stern School of Business. "The question is when. I would say probably soon after the default rates peak, and that has happened, I suspect."
Altman has devised a widely used method for predicting when companies are likely to default, or become unable to pay interest on their bonds.
Junk-bond prices have fallen 6 percent this year through Thursday, according to the Merrill Lynch Master High Yield Index. That is their worst record since 1990, when the index fell 4.4 percent for the year. Because prices and yields move in opposite directions, junk-bond yields have soared, to an average of 12.7 percent, according to Moody's Investors Service, 8.9 percentage points higher than the 10-year Treasury note.
Default rates on junk bonds peaked at 10.7 percent in January and were at 10.1 percent in July, according to Moody's. The last time rates jumped to such levels was in June 1991, when they hit 12.8 percent. The agency's calculation measures the percentage of defaulting companies out of all American corporate bond issuers, while Altman looks at the total dollar value of nonperforming debt. His calculations show a default rate of 11.3 percent in July; it is likely to surpass 12 percent this month.
The rate of corporate defaults is closely linked to the economy. When the economy improves, the default rate would be expected to decline, with prices rising and yields falling. An investor who could time this move would earn substantial profits, and some risk takers have begun to return to the sector. Moody's has predicted that default rates will dip to 9 percent by year-end and to 8.5 percent by July 2003.
"Because of these attractive yields and the lack of other options out there to get a decent return, this asset class has taken in a huge chunk of money recently," said Sandy R. Rufenacht, manager of the Janus High-Yield fund in Denver. Investors are hoping for a rebound rivaling that of 1991, when junk-bond prices rocketed 34.6 percent, according to the Master High Yield Index.
Still, some people say the current risks outweigh potential gains. "Now is not a good time because I think we are still a few months away from the bottom of the equities market," and junk bonds could fall further, said Peter J. Petas, chief global strategist at CreditSights, an independent research firm in New York.
Unforeseen circumstances
The string of accounting scandals since spring erased the modest gains that junk bonds made earlier in the year. The debt of companies like WorldCom, Tyco International and Qwest Communications ranked as investment grade. When these bonds collapsed, investor anxiety spread to the junk sector, sending prices lower.
Mark J. Vaselkiv, president of the T. Rowe Price High Yield fund, said WorldCom bonds, at 0.25 percent of the fund's assets, eroded his performance by two-tenths of a percentage point for the year. He recently sold the bond at 12 cents on the dollar, down from the 45 cents he paid in mid-May.
RSS