Junk bonds may carry significant risk

Many investors are being enticed by tremendous yields to take a chance on junk bonds.

If you are one of them, be aware of the risks you are taking.

“I think we might see the highest default rate ever,” said Edward Altman, a New York University Stern School of Business professor and expert on bankruptcy and distressed bonds, topping the 12.8 percent rate in 2002.

Even the savviest investors could have difficulty maneuvering in such an environment. Already, hedge funds that specialize in distressed debt lost an average of 27 percent last year, and high-yield – or so-called “junk” – bonds are likely to exert greater challenges for investors in the months ahead.

Currently, junk bonds are yielding an average of roughly 17 percent.

“You hear yields are attractive,” Altman told professionals who manage investments for wealthy people at a recent CFA Institute conference in Chicago. “Well, good luck to you. You’ll do well if there are not too many defaults. But we are predicting double digits. Then, you could have a problem.”

He thinks a 12.3 percent default rate among high-yield bonds is likely this year, and he would not be surprised by 15.4 percent or even 18.3 percent. With yields far above Treasuries, the market is telling investors that an 18.3 percent default rate is likely, Altman said.

Even a 12.3 percent rate would approach the peak in 2002, a period in which many technology companies failed after the tech stock bubble burst in 2000.

Now, he said he is concerned because of lax lending practices in 2006 and 2007. For example, some borrowers were provided “covenant light” loans, which means that lenders have not had the right to monitor many financial conditions and force companies to be more careful. This is a major change from the cautious approach lenders used in the past.

The result of lax lending, plus the difficulty obtaining new loans recently, means that many companies will go into bankruptcy court in weaker condition than they usually would, and may collapse rather than pay bondholders a small amount and re-emerge from bankruptcy.

When there is a high level of defaults, bondholders should expect a low level of recoveries, Altman said. This year, he said he believes investors will receive an average of only about 25 cents on the dollar, and perhaps closer to 21 cents if his most dire projections come true.

Last year, the high-yield default rate was only about 4.6 percent. But that should not comfort investors. Typically, defaults are the highest late in recessions.

So investors who put money into high-yield bonds should expect to go through declines before finally experiencing gains.

In 2000, for example, high-yield bonds lost about 5 percent, according to the Citigroup high-yield bond index. In 2001, they gained 5.4 percent, and in 2002 lost 1.5 percent. In 2003, investors enjoyed a 30.6 percent return. Overall, during the nerve-racking four-year period, an investor would have averaged about a 7 percent return a year, Altman said.

Some investors might wonder if the grief is worth it for such results. And for those looking at history, there is a lot of variation. In 1990, an investor would have lost about 8.5 percent in high-yield, and then enjoyed a 43 percent return in 1991.

The current environment is not for the faint of heart.

Some economists are predicting a different type of economic recovery than is typical. Rather than hitting a bottom, and then continuing upward, they are predicting a couple of years of rolling recessions – or moving in and out of recessions.

If that’s the case, Altman said it is not as likely that the big burst of returns will come. Rather, defaults could stay elevated without sharp relief.

In such an environment, investors would be taking tremendous chances investing in individual high-yield bonds, or those called “non-investment-grade” bonds.

Even safer investment-grade bonds could pose a risk if their default rate reaches high levels.

Consequently, Warren Pierson, senior portfolio manager for the Baird Intermediate Bond Fund, said he is avoiding high-yield bonds entirely in the fund.

He sees no need to take the risks.

Given worries about risks in the market, he said, he can invest in high-quality bonds and earn about an 8 percent return – close to the 9.4 percent historical average in the stock market.

The opportunities appear so great, he said, he has been adding corporate bonds to the portfolio so they now make up about 40 percent, versus 30 percent previously, with the rest in a variety of government bonds.

He said the economic environment is so uncharted that he would be reluctant to invest entirely in corporate bonds.

? 2009, Chicago Tribune. Source: McClatchy-Tribune Information Services.