Riskiest Bonds Make Up Bigger Slice Of Junk Market

Debt from the riskiest companies in the U.S. is making up a larger part of the high yield market than ever before - a trend that does not bode well for the already troubling rate of junk bond defaults.

The default rate on high yield bonds has surged to 6.2% for the last 12 months, from just 4% in all of 1998. But rather than predicting a rebound, analysts are warning that default rates are unlikely to peak before the second half of 2000, due in large part to the huge growth of the lowest-rated segment of the junk market.

"We are now paying the price for being so tolerant of credit risk during 1997 and the first half of 1998," said John Lonski, chief economist at Moody's Investors Service.

The percentage of all junk bonds rated B3 or Caa - the lowest labels awarded by credit rating agencies to companies that are not in default - is at a historic high. This lowest slice of the ratings spectrum currently accounts for about 35% of all outstanding speculative-grade bonds. That number represents a significant deterioration in the credit quality of the junk market since the period from 1992 to 1996, when such securities made up just 24% of the overall market, according to Moody's.

The reasons for this deterioration are clear: record issuance and a spike in downgrades. During 1997 and the first half of 1998 the junk market experienced never-before-seen levels of issuance from its lowest-rated companies. In the 12-month period ending in May of 1998, companies rated B3 or Caa issued a staggering $77.8 billion in debt, up from $49.5 billion in 1997 and only $23.6 billion in 1996.

Ironically, this surge was sparked in part by the fact that junk default rates had bottomed out at just 1.9% in 1996, making investors much bolder in their evaluation of credit risk. In fact, investors became so aggressive in buying this low-rated debt that the median spread on Caa-rated paper was driven to just 536 basis points above U.S. Treasurys in early 1998, from an average of 819 bps from 1995 to 1997.

As speculative-grade companies began issuing more paper in order to take advantage of this demand, the ranks of companies wearing B3 and Caa pins also began to swell. In late 1998 and 1999 corporate downgrades to B3 or Caa rose sharply. Through the first three quarters of this year, the B3/Caa segment of the market has seen a net increase of 70 companies. That number has already surpassed last year, in which the ratings category saw a net increase of 62 companies. To put those numbers in context, the group saw a net increase of just 14 companies in 1997.

"If you allow the popularity of low-rated bonds to swell, eventually the incident of default will begin to rise," Lonski said.

Not all analysts agree that the deterioration of credit quality is the prime cause of the jump in junk default rates, however. The extended slump in oil prices also had a disproportionate effect on non-investment grade issuers and might be the real reason that junk defaults have soared, said the head of high yield research at one Wall Street shop.

The research head noted that about $4 billion of the $18.5 billion in junk defaults so far this year has been in the energy sector. When the impact of the energy sector's weakness is factored out of the market, 1999 default rates fall roughly in line with the market's historic annual average on a par amount basis, he said. "If oil prices had been in a more normal range," he added, "we might be looking at a completely different picture."