Down at the dog poundNov 9th 2004
From The Economist Global Agenda
SourceWhy are so many investors prepared to lend to lowly rated companies at dangerously thin rates of interest?WHAT, Buttonwood wonders, is the world’s most expensive security? He finds many an investment eminently resistable on account of its being exorbitantly pricey. The list includes, inter alia, most technology stocks, many of their less whizzy counterparts, ten-year Japanese government bonds yielding 1.5%, and houses in London. But there is at least some sort of future in which he could imagine that buyers of these might not lose a packet. It is, however, hard to imagine a future in which anyone will do anything but lose their shirts from buying the 10% bond maturing in 2012 issued by the Mueller Group, which does something widgety with pipes.
The bonds are subordinated, which means that in the event of default, the holders rank lower than other creditors, of which there are many because the company borrows so much. The bonds carry a lowly rating of Caa1 from Moody’s, a big rating agency. In March, Moody’s downgraded the company after becoming concerned about a big debt issue that it would use to pay $396m to DLJ Merchant Banking Partners, a private-equity firm that held 94% of the stock of the holding company. Loading up with debt to pay holders of company stock is the sort of thing that unnerves bond investors, who receive only the coupon (ie, interest).
Or it should do. In fact, the price of the Mueller 10% 2012 has soared. The bonds are now trading at a price of about $108 for every $100 of bonds, giving them a yield to maturity of 8.15%. Since they were issued at “par”, or face value, only in April, they have, it is clear, proved a particularly toothsome investment. Having risen so much already, are they still a good buy? Michael Lewitt of Harch Capital Management, a hedge fund that specialises in selling short expensive bonds, in the hope of buying them back cheaper, thinks not. Mueller’s bonds are but one of a bucketful of lowly rated names that he heartily dislikes (and is thus short of) because they are so expensive. Life has been tough of late for Mr Lewitt, because the market is chock-a-block with bonds of jaw-dropping expensiveness that, in recent weeks, instead of getting cheaper, have instead flown off stockbrokers’ shelves.
So there is, it is clear, a school of investors that thinks such bonds are still cheap. Buttonwood can’t help but feel they should have done a class in finance. There are, it is true, good reasons why junk bonds should have become more expensive than they were in, say, the autumn of 2002, when the interest-rate “spread” on junk over Treasuries reached ten percentage points or thereabouts (the number is pretty meaningless because there wasn’t any trading to speak of). Since then, the nightmares about the financial health of corporate America have disappeared as the economy has been bathed in sunlight, profits have risen and companies have apparently become sharply less indebted. Junk-bond defaults have fallen from a peak of 10.5% of all issuers in the year to March 2002, to 2.3%.
These are the respectable reasons for bidding up the price of junk. The bad reason is that it offers a sniff of yield in a world where returns are hard to come by. It is a bad reason because the good folks that are snapping up the bonds at their current derisory yield are not being rewarded for the risks they are taking.
When you buy a corporate bond, you buy, in essence, the risk-free rate (Treasuries) plus something extra to compensate for the risk that you won’t get your money back. The higher the risk that the company won’t repay, the more that any sensible investor should demand in compensation for lending to it. Investors might get a bit of extra oomph from their investment were their borrowers to get upgraded, but the downside for buyers of corporate debt is generally much greater than the upside, compared with equities: you get the money back plus a bit of interest if you’re lucky, and if you’re unlucky you don’t.
The dodgier the issuer, the more it has risen. The highest-flying markets in recent weeks have been for bonds issued by the least creditworthy companies: those rated B and lower. (For comparison, the highest is AAA and D stands for default.) The Merrill Lynch index of B-rated corporate bonds now yields 7.4%—a quarter of a point less than a month ago, even though Treasury-bond yields are higher.
Just how unlikely investors are to get their money back can be gauged by the default statistics that the rating agencies produce. According to Standard & Poor’s, another big rating agency, a bit more than 13% of issuers with a rating of B- or less will default within a year, and 39% of them within five years. For those with a rating of CCC (roughly, its equivalent of Caa1, Moody’s rating for Mueller) the figures are 30% and 53%. According to Standard & Poor’s, 85% of junk bonds issued so far this year have a maturity of more than seven years. Chances are, in other words, that anyone hanging on to such bonds until maturity will not get their money back.
Some investors might think they have a better chance of being repaid than those numbers suggest, because of the decline in defaults. But Standard & Poor’s points out that when issuance of bonds with a rating of B- or lower exceeds 30% of total junk-bond issuance for any length of time, defaults pick up within a couple of years. So far this year, the figure is about 40%. Issuance of CCC bonds accounts for some 12% of junk issuance. That should surprise no one: supply has risen to meet demand. What self-respecting finance director would shun an opportunity to issue extraordinarily cheap debt to eager punters? At some point, however, the cycle will turn, the economy will slow, defaults will rise, appetite for risky bonds at suicidally thin spreads will evaporate, and investors will wish they had visited Crufts, not the local dog pound.
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