Junk Bond Risks Soar

The riskiest corporate debtors in the U.S. aren't growing fast enough to pay down their borrowings, increasing the risk for bond investors at a time when valuations are already at about record highs.

That's the conclusion of Deutsche Bank AG, which estimates that the biggest jump in earnings in almost three years may be coming too late for speculative-grade borrowers as the amount of debt on balance sheets climbs back to levels seen in early 2008 before the financial crisis. To make matters worse, their ability to make interest payments is about where it was in 2007, even as the Federal Reserve has held its benchmark rate close to zero.

“We expect the next restructuring cycle will be dominated by companies with good operations but not able to grow into their balance sheets or refinance maturing debt,” Kenneth Buckfire, president of New York-based restructuring firm Miller Buckfire & Co., said by email Tuesday.

Investors have piled into junk bonds for their relatively high yields amid the suppressed rates. That has allowed the least creditworthy borrowers to raise $1.64 trillion in the bond market since the end of 2008, according to data compiled by Bloomberg.

That led to average annual returns of 18.6 percent from 2009 through 2013, compared with 17.7 percent for stocks as measured by gains in the Bank of America Merrill Lynch U.S. High Yield Index and the Standard & Poor's 500 Index.

Debt exceeds earnings before interest, taxes, depreciation and amortization by about four times at speculative-grade companies, near 2008 levels, Deutsche Bank strategists Oleg Melentyev and Daniel Sorid wrote in a Nov. 7 report. Leverage rose even as cash flow grew 12 percent at those companies that had reported third-quarter results, according to the New York-based analysts.

The Fed has held its benchmark rate between zero and 0.25 percent since the end of 2008 to spur economic growth. Yields on junk-rated debt, which is rated below BBB- by S&P and less than Baa3 by Moody's Investors Service, have fallen to 6.36 percent, from a peak of more than 22 percent at the end of 2008, according to Bank of America index data. Yields touched a record low 5.7 percent on June 23.

Debt Coverage

Even with historically low borrowing costs, the ability of companies to make interest payments is about the same as before the global financial crisis. Coverage ratios, a measure of earnings to interest expense, average about 4 times for U.S. high-yield companies, compared with an average of 3.8 times in 2007 and early 2008, according to Deutsche Bank. Companies with lower ratios have higher debt burdens.

While the Fed stopped buying bonds last month under a program known as quantitative easing, it pledged to keep interest rates low for a “considerable time.”

“We're closer to the end of the credit cycle, but we're not quite there,” said Scott Colyer, chief executive officer of Monument, Colorado-based Advisors Asset Management Inc., which oversees more than $15 billion. “That usually comes when the Fed is trying to slow down a powerful economy. At this point in time, I don't see it.”

More investors are anticipating declining credit quality in the riskiest debt over the next six months, while expectations for investment-grade bonds haven't changed, according to a November survey of bond investors by Bank of America Corp.

Most expect the default rate to climb to a range of 2 percent to 4 percent in the next year, according to the survey. That's above the current 1.7 percent rate tracked by Moody's and the average of 4.4 percent since 1993.

“You're deteriorating from a very, very good level right now and you're entering into a more normal environment,” Michael Contopoulos, head of high-yield and leveraged-loan strategy at Bank of America in New York, said Tuesday in a telephone interview. “The companies that we look at and we think could default next year probably should have gone in the past anyway.”

Even as the U.S. economy expanded at a 3.5 percent rate in the third quarter, capping its strongest six months in more than a decade, signs that global growth is slowing has raised concern among investors that the riskiest companies might struggle.

The International Monetary Fund reduced its outlook on Oct. 7 for global growth in 2015 and Fed Vice Chair Stanley Fischer said in a speech on Oct. 11 that a slowdown may weigh on the world's largest economy.

“As the economy slows and we move into the next phase of the cycle, we expect defaults to increase,” Michael Sohr, a money manager at AllianceBernstein Holding LP, which oversees more than $30 billion of high-yield debt, said Tuesday in a telephone interview.

Bloomberg News

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