JUNK BONDS FACE THE BIG UNKNOWN The high-yield debt market coped well with its recent jitters. But with fear of recession mounting, think seriously about weeding your junk portfolio.
By John Paul Newport Jr. REPORTER ASSOCIATE Edward C. Baig

(FORTUNE Magazine) – THE JUNK-BOND JITTERS struck again in mid-April. Unlike previous lapses of confidence in the market, which followed events like the indictment of Ivan Boesky, no single cause was to blame this time. A variety of negatives, from rising interest rates to rumors of huge withdrawals from bond funds to a misinterpreted academic study, converged to drive down prices of some issues as much as $10 a day on a bond with a $1,000 face value. Two lessons emerge from the episode. First, the high-yield market, though young, appears both large enough -- $185 billion of the bonds are outstanding -- and resilient enough to cope with at least moderate stress. The sense of upheaval in April prevailed for perhaps a week, during which a typical bond lost $30 to $40 in value. But then prices regained about half the ground lost, remaining stable ever since. Second, without question, the dominant fear now stalking the market is recession. No one quite knows what to expect when the next economic downturn comes -- it would be the first to hit junkland since the market got big in the mid-1980s -- but almost everyone is exceedingly leery. Should an investor be buying junk now? To answer that, he has to understand how the market works and relate that to his own particular circumstances. A concatenation of economic concerns helped trigger the market break in ! April. As interest rates rose, the difference between what investors could earn from junk bonds and from risk-free Treasuries narrowed. According to theory, junk must pay generous interest to compensate buyers for the added risk of default. When the spread between the yields paid on junk and on Treasury bonds shrank too far -- it was approaching 3.5 percentage points in April, vs. a historical average of about four -- many investors decided to shun junk, and prices tumbled, boosting yields. By the end of April the yield spread had widened again to about 4.5 points. Usually the market doesn't react as strongly to interest rate fluctuations. But in April several other worries were also jangling buyers' nerves. Many had to do with an anticipated excess of supply. The most daunting concern was the looming prospect of more than $9 billion in new high-yield issues slated for the second quarter, headlined by RJR Nabisco's $4 billion public offering -- the biggest new issue ever -- in early May. In all of 1988, by comparison, underwriters floated a total of $26 billion of new junk. Many would-be buyers, squeamish about high-yield bonds in general, viewed RJR as a bellwether deal and held back on purchases. Says Mario A. Monello, an executive vice president in the high-yield department at Shearson Lehman Hutton: ''The market is waiting to see how well RJR is distributed. The depth of the buyers' list, the efficiency of execution, and the timeliness of the sale will dictate the direction of the marketplace.'' The market buzzed with other anxiety-provoking stories as well. Several junk mutual funds supposedly were finding that investors had begun withdrawing more money than they were putting in. At the same time, thrifts were said to be selling off big chunks of their junk portfolios in expectation of new regulations that would require them to raise the quality of their assets. As it turned out, in neither case did reality prove as scary as the gossip. While aggregate figures for junk funds' redemption through April are not yet available, only a handful of funds actually reported net cash outflow, and there was little other evidence to suggest a mass exodus. As for the thrifts, some have indeed reduced their junk exposure in recent months, but again, market participants see no signs of a major sell-off, nor would the Bush Administration's regulatory package now winding through Congress compel such divestitures. In fact, a recent study by the General Accounting Office absolves high-yield debt of charges that it contributed to the thrift industry's woes. Rumors also swirled in April that Solomon Asset Management, one of the largest investment firms specializing in high-yields, would have to dump a significant part of its $1.8 billion in holdings to meet customer redemption orders. The rumors arose after founder David Solomon unexpectedly retired and agreed to cooperate with federal prosecutors in the case against junk-bond kingpin Michael Milken. But the Solomon firm reports that only two customers have jumped ship and denies that it is selling off assets. A MORE ELEVATED BIT of folderol making the rounds was that a study by an associate professor at Harvard business school, Paul Asquith, and two co- authors had uncovered far higher junk default rates than suggested by previous research. The study did show that 34% of the junk bonds issued in 1977 and 1978 had defaulted in the following decade. But that number is about the same as the default figure arrived at last year in a study by New York University professor Edward Altman, long the reigning academic authority on junk. In any event, the Harvard study does not contradict the 2.5% annual default rate usually cited in discussions of high-yield bonds: The higher figures reflect how many bonds of all those issued in a particular period eventually default, while the lower figure represents the percentage of all junk bonds outstanding that default in a single year. The 2.5% figure may understate the year-by-year default experience of a buy- and-hold junk-bond investor. Bonds go bad more frequently as they get older, and any sampling of the overall junk market, which has been doubling in size every two years, is overweighted with recent, healthier issues. Nevertheless, and this is a point neglected in much of the furor over the Harvard study, Altman's research suggests that even with long-term default rates above 30%, an investor who held on to a diversified portfolio of junk bonds issued ten years ago would have earned returns comfortably higher than what Treasuries provided, largely because of the compounding effect of all that extra interest. The main shortcoming of any research based on past performance is that it cannot predict what will happen in the next economic downturn. Most of the market's fears about recession have focused on the potentially high rate of defaults. Asquith's Harvard study of 741 high-yield bonds shows that the average rating of junk bonds has declined dramatically since the early 1980s. By 1986 the percentage of new issues carrying the highest junk rating, BB, was half what it was in 1979, while the portion rated considerably lower at CCC was three times greater. The longer a recession, the more likely that low- rated companies will run out of cash to pay interest. While not denying the risks, junk-bond advocates do make a few valid points about defaults. All junk issuers are not alike. More than 25% of the companies in the S&P 500 have bonds in junk-rated categories, and in many cases a downturn would not seriously impair their cash flow. Should interest rates soar, companies with fixed-interest junk debt may have less trouble making payments than companies with bank loans tied to the prime rate. ''Homework is the key,'' contends Edward D'Alelio, chief investment officer for the high-yield group at Putnam Management Co. He recommends that recession-fearful investors favor junk debt of companies whose businesses are not cyclical -- cable TV companies, for example -- and avoid situations where cash flow is iffy or solvency depends on the sale of white-elephant assets. When companies do default, junk holders typically recover around 40% of the bond's face value. Factoring in such recoveries, junk default rates would have to triple before investors' returns would be worse than returns earned on risk-free Treasuries, at least according to some studies. Says William Buecking, director of fixed-income investments for Kemper Financial Services: ''The yield spreads currently available -- up to five points in the single- B category -- can take care of a lot of defaults.'' Investors should worry as much or more about liquidity. No central exchange exists for trading bonds. When an investor wants to sell, he or she must trade through an investment firm. For the bigger junk issues, any of a dozen Wall Street firms will make a market, but for medium-size and smaller bonds, only the original underwriter may. Come a severe recession or sell-off, finding a buyer for lesser junk could prove mighty tough. Market-making brokers have only so much capital available to buy bonds from eager sellers. In hard times whatever market there is could be crowded with sellers: Because some fixed-income managers must regularly declare their holdings at market values, they have a strong incentive to exit if it looks like a crash is on the way. And in a stricken market some traditional means of rescuing marginal companies -- such as issuing new bonds in exchange for old ones -- could disappear. Says Gerald Perritt, editor of a mutual fund letter published by Investment Information Services: ''The secondary market for these things is so doggone thin, you're going to find bids going right to the floor.'' The junk-bond market has been lucky to grow up during one of the longest economic expansions on record. Issuers, interest-loving investors, and especially Wall Street firms -- which earn far higher underwriting fees and trading profits on junk than on other forms of debt -- have a vested interest in seeing it survive the next recession and grow still larger. Advocates point out that fewer than 5% of companies that might conceivably issue junk debt have done so, and big pools of bank and insurance company loans could yet be converted into junk. Such at least are the dreams for junk dancing in the heads of Wall Street honchos. For now, though, an investor would be better advised to keep his eye on more mundane concerns, such as the cash flow and recession plans of the junk-issuing companies in his portfolio.

CHART: NOT AVAILABLE CREDIT: DREXEL BURNHAM LAMBERT CAPTION: Difference in Yields Between Treasury Bonds and Junk Bonds THE VOLATILE RISK PREMIUM THAT JUNK INVESTORS EARN The yield spread narrowed after the 1987 crash, leading eventually to April's market correction. Prices plunged, boosting the yield advantage of junk to over four points again.