S&P Sees Rising Junk Bond Risks

Risks in high-yield bonds are growing as the already flagging United States economy shows more signs of slowing drastically, according to Diane Vazza, head of global fixed-income research at Standard and Poor’s Ratings.

Junk bonds provide higher income than investment-grade bonds to compensate investors for the bonds’ higher risk of default. However, Vazza said in a research report there are 10 headwinds for the market, including rising defaults, a deterioration in credit quality and reduced ranks of junk-bond investors, especially in the hedge-fund arena.

A deteriorating economy, weaker earnings prospects and lending constraints will push defaults higher, Vazza said. Default rates should continue to climb throughout the year, with the 12-month-trailing U.S. speculative-grade default rate hitting 4.7 percent by the first quarter of 2009, she said.

As default pressures mount, more firms may exercise payment-in-kind (PIK) features, paying bondholders with additional securities instead of coupons. “Another sign of stress is the increase in the number of borrowers seeking covenant relief,” she said. “However, the increased use of PIK-toggle notes and covenant-lite loans in the past two years could help mitigate the increase in defaults in 2008, by either providing time for firms or the economy in general to rebound or by extending the default timing into 2009.”

In the meantime, balance sheet repair by banks and brokers will limit new issuance. “Lending standards have tightened, and underwriters have lowered their risk-tolerance levels,” Vazza said. High-yield issuance in the United States for the first half of 2008 totaled $30 billion, the lowest since the dismal $24 billion in the first half of 2000, she noted.

Because risk carries a higher premium today, highly leveraged issuers will continue to find it challenging to access the high-yield bond market, she said. In 2007, 51 percent of new issuance in the high-yield market was rated ‘single-B-minus’ or below, with 26.3 percent rated ‘triple-C-plus’ or below. In the first half of 2008, only 15.5 percent of new supply was rated ‘single-B-minus’ or below, and much of this was tied to delayed deals from 2007.

At the same time, high-yield spreads will likely remain in the previous two months’ trading range of 640 to 700 basis points over Treasuries, but with a higher risk of extended widening, given the uncertainty about the economic and financial market prospects and expectations of rising defaults in the next four quarters, according to Vazza.

Credit quality will slide further in the second half, with downgrades continuing at a heightened pace. In June, 33 percent of junk-rated firms were on review for downgrade or had a negative outlook, the highest percentage since November 2003, indicating more downgrades are on the way, she said.

Deterioration will be most pronounced in consumer-sensitive sectors such as retail, media and entertainment, and consumer products, and that pressure will remain for the rest of the year. “These sectors consistently rank highest in risk metrics such as the number of distressed companies,” Vazza said. Distressed is defined as speculative-grade companies with securities trading in excess of 1,000 basis points above U.S. Treasuries.

Also slowing new junk-bond issuances is that investors may recover less when companies default. “After five years of increasing recovery values, ultimate recoveries in the current credit cycle are likely to reverse,” Vazza said. Recovery values will be affected by several new factors, including the growth of institutional investors rather than banks as holders of debt, a trend toward liquidations versus reorganizations, and the proliferation of credit default swaps as a hedging tool.

And the ranks of high-yield investors may thin even more, especially among hedge funds who rely on levering up their fixed-income investments to generate attractive returns. “With brokers unwilling to extend credit everywhere, the inability to add leverage could keep some funds from continuing to play in the high-yield space,” Vazza said.

(Jennifer Ablan writes for Reuters.)