By Heidi N. Moore, contributor
Can a bubble be a force for good? It can, if you consider the miraculous story of redemption of high-yield bonds.
Junk bonds are supposed to be risky — in fact, they’re the riskiest kind of corporate debt you can buy, because the companies that issue them have a greater chance of not being able to pay their debt and falling into bankruptcy. At least, that is true in normal years. In 2010, companies that issue high-yield bonds are defaulting on that debt at a rate of only around 1%, compared with more like 14% in 2009, according to a new report from Fitch Ratings credit analyst Mariarosa Verde. Verde notes that there are both fewer and smaller companies defaulting on their high-yield debt in 2010. For a bit of context, the current default rate on junk bonds compares to a historical default rate between 4% and 68%, depending on the junk bond’s rating. Now junk bond defaults are so low that they are half the historical default rate for highly rated — or investment-grade — corporate debt, a which historically maintained a 2% default rate. Municipal bonds issued by the most financially sound cities and states historically default by 0.7%. So right now, junk bonds are about as likely to default as highly rated munis.
If you feel like you just fell through the looking glass, you’re not alone. Junk bonds are, to say the least, unlikely heroes. Former Treasury Secretary Hank Paulson has said that he was blindsided by the fall of AIG
because he and his staff were expecting private equity-owned companies, which are the ones more likely to be loaded with junk debt, to be victims of the next debt crisis. In a recent interview with Charlie Rose, private equity investor Jonathan Nelson of Providence also conceded that the private equity industry was surprised it was able to dodge the debt bullet. Between 2005 and 2007, there were $1.7 trillion of leveraged buyouts, all, of course, fueled by junk bonds. The problem even earned a book, reporter Josh Kosman’s The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis.
Add to the mystery of the junk market’s newly rude health this: Junk bonds looked suspiciously bubblicious this year, even though the recession still looked pretty bad; both prices and issuance rose to nose-bleed heights. In fact, so many companies with low credit ratings rushed to the markets this year that they raised $150 billion through 474 deals — a 141% increase in volume from 2009. In just four months, junk-bond issuance in 2010 set a record, exceeding every single full year before this. The junk bond market grew to 6.2% of all the activity in the debt capital markets, nearly triple its previous 2.3% level. At the same time, prices were jumping: Junk bonds were selling at 99.67 cents on the dollar, a 40% jump from their prices during the depths of the credit crisis, when some bonds dropped as low as 58 cents on the dollar. The enthusiasm is so high that Blackstone’s GSO Capital even created a retail fund composed of leveraged loans.
What happened to reverse the inauspicious fortunes of the junk-bond market, then? One factor might have been the determination of many private equity firms to not waste a bubble. The majority of this year’s junk-bond issuance was a move to refinance by companies to help push off debt to as late as 2015, according to Bank of America Merrill Lynch and Fitch data. This strategy is commonly derided as extend-and-pretend, but for companies that can put off thinking about paying down huge chunks of debt before the economy turns around — well, that relief is very real.
Of course, it helps the junk-bond market’s current numbers that most of the weakest companies already defaulted during the great shakeout of 2009, which also reduced the competition for investor dollars. And those companies that have survived have done so primarily through cost-cutting — the primary strategy used by many PE firms this year to keep their portfolio companies above water. Fitch surveyed about 191 of the junk-rated companies rated B and BB and found that revenue and EBITDA grew, as did cash balances, while deep cuts to capital expenditures and operating costs helped the companies survive.
Note, however, that those newly shorn capital expenditures are a short-term solution: They “have boosted liquidity in the near term but are not likely to be sustainable without affecting top-line growth,” Fitch said. Top-line growth and greater cash flow is what junk-rated companies really need to be able to stay on top of their debt. Of course, the market still has problems; the mega-buyouts of companies including Clear Channel Communications and Harrah’s have loaded those companies down with debt that will still be hard to pay. And last year’s high default rate marks a real failure for the private equity industry, in part because much of the high-yield debt their companies issued in 2005, 2006 and 2007 was designed specifically not to default until a company was so far in trouble that its best choice was bankruptcy.
There were a few experts who called this one. Marty Fridson, the well-known high-yield expert is on; Loomis Sayles & Co. and MFC Global Investment Management also all predicted that junk bonds would be winners this year. Since the sovereign debt crisis set in during May, the junk bond mania seems to have abated. But that mania may have saved a lot of people a lot of trouble in the next couple of years.
–Heidi Moore is Sweeping the Street for the next two weeks while Colin Barr is on Vacation.