NEW YORK-The admonition that those who forget the past are condemned to repeat it applies to investors in high-yield bonds, many sold by companies in a variety of wireless telecommunications-related businesses.
For junk-bond investors, 1988 should live on in infamy, offering a cautionary tale for 1998, said Kingman D. Penniman, president and chief executive officer of KDP Investment Advisors Inc., Burlington, Vt.
“Net inflows into mutual funds in 1986 resulted in an increase in the bad cohort (of bonds rated below B-, including unrated debt). Two years later, there was a substantial increase in the default rate,” he said. The public market, where higher grade debt is issued “isn’t so much of a problem” compared with the Rule 144a private placement market, “which is a quick pipeline for lower quality-credits (accounting for) nearly half of all new issues lately.”
Penniman spoke at a recent meeting of the New York Society of Security Analysts. The seminar’s moderator, Martin Fridson, chief high-yield strategist for Merrill Lynch & Co., New York, introduced Penniman as “probably the most frequently quoted expert on credit market quality.”
Communications, which KDP has divided into six sub-sectors, was the single largest industry segment tapping the high-yield bond market in 1997 and the first five months of 1998. It accounted for 22 percent of the $169.4 billion in new domestic junk-bond issuance and 70 percent of all CCC or unrated debt. Penniman termed these securities “blueprint and a prayer” deals.
“You need a prayer because you’re not compensated for a blueprint that’s still to be in a highly competitive market undergoing rapid technology changes within an uncertain regulatory environment.
“These are concepts that have been oversold due to misplaced optimism. Don’t buy a pig in a poke. Check what’s inside the bag first.”
Despite the generally low-credit quality of the new high-yield debt sold by communications companies, until recently, there had been an upsurge in upgrades of this debt, Penniman said. Today, the situation is reversing itself.
He suggested several factors contributing to this downgrade trend: a slowdown in economic activity, which will “take a bite in 1999;” and the difficulty some companies have had and will have in selling stock concurrently with bonds to enhance the appeal of their debt deals; the increasing debt leverage taken on by companies, whose managers “will find a way to spend money if you (the bond buyers) throw it at them.”
Investors, hell-bent on chasing yields, have gotten adequate compensation for credit risk in the junk-bond market, which has outperformed most other fixed-income finance sectors. However, they largely have failed to demand adequate compensation for interest-rate risk.
“In communications, high-yield mutual-fund investors have opted to act like venture capitalists, but they are only getting a rate of return half that of the S&P 500.”
While the investment community as a whole has been somewhat lax in demanding adequate risk premiums from junk-bond issuers, “the market also is excruciatingly harsh on companies downgraded from the `B’ range to the `C’ range. It’s a free fall. I’ve seen bonds trading at 70 (cents) to 80 cents on the dollar.”
On average, only about 7 percent of all new high-yield debt securities reach maturity. Most companies either go public and use proceeds of the newly sold stock to repay outstanding debt or they default on the bonds. Recently, most companies went public, but that is likely to change, Penniman said.
“With a $400 billion domestic market, there will be lots of opportunities in distressed companies shortly,” he said.
