May 7 , 2003

In 1992, high yield bonds showed by far the best returns of any investment available.  So far in 2003, junk bonds (another name for high yielding but risky securities) again are leading the investment pack.  Is this coincidence, or are there similarities that may provide guides for future results?

The first glaring similarity is that high yield bonds offered more than 10 percentage points more than treasury bonds with comparable maturities during each of the recessions preceding the surge in bond values.  This probably was the result of the second similarity, defaults soared to more than 10 percent in each recession. 

A third similarity is that the Federal Reserve appeared to have engineered unusually low short term interest rates in both periods.  In the early 1990s, the Fed wanted to create a large spread between short and long term interest rates so that banks could borrow low and lend high.  Banks had lost substantial lending capacity through the default of bad real estate loans and needed to rebuild their capital. 

Today, the banks have few lending problems, except for avoiding lower credit quality from some would be borrowers.  Of course, loan write-offs rose during the latest recession, but not to the crisis levels of the earlier period.

However, a sluggish recovery this past year has led the Federal Reserve to push down interest rates to stimulate the economy.  Those lower rates have caused a boom in housing and sales incentives that periodically cause a burst in vehicle sales.  Capital spending, by contrast, remains sluggish. 

Furthermore, interest rates continue to come down throughout the world, just as rates did in the early 1990s. 

Probably the most interesting similarity is that, despite little job growth and a sluggish economy, the rate of bond default has dropped sharply.  By 1993, that 10 percent default had fallen below 6 percent.  Eventually, the default rate and the spread over treasuries reached less than 5 percent. 

The default rate also has fallen significantly in recent months--to less than 8 percent.  Those 10 percentage points of additional interest yield have declined to less than 7 percentage points.  Thus, the latest junk bond rally looks very similar to that surge in the early 1990s. 

If the similarities continue, we can expect three outcomes.  First, as borrowing costs fall for the lower credit worthy companies, those companies will be able to show profit gains.  Lower defaults mean lower interest rates,  which lead to even further reductions in defaults.  At some point, the increased access to borrowing will begin to generate the capital spending that economists still cannot spot. 

Second, high yield bonds will continue to perform well until the interest rate spread and default rates both fall to less than 5 percentage points.  In the early 1990s, the high yield rally took about two years to finally reach those favorable conditions. 

Third, once the rally is over, bond holders will be slow to realize how large the flood of new borrowing at high levels of leverage is impacting the market.  Indeed, an increase in supply ultimately will push rates back up, but not until some companies have acquired too much debt.  This excess usually occurs two to three years after the large rally. 

In short, high yield bond investing requires continuous analysis of the credit quality of the companies issuing the debt.  A buy and hold strategy is not appropriate for such instruments.  Unfortunately, this leads to volatility in asset prices and investment risk that the average investor might simply want to avoid. 

Nevertheless, the price of high yield bonds appreciated at an annual rate of 24 percent in those eighteen months of rally in the early 1990s.  And you also received the coupon, which was an additional 12 to 14 percent. 

Aside from the deterioration in credit quality, the other risk to high yield investing at this time is that the economy does not improve.  Junk bonds are offerings from companies that are heavily leveraged.  If a recession reappears, defaults will jump rapidly.  In short, you can lose investment value almost as fast as a company selling pet food over the internet if the economy deteriorates. 

On the other hand, if you believe, as I do, that we are replaying the early 1990s in the high yield market, you have another year of very attractive returns before the music stops on this investment opportunity. 


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