New York Times - January 21, 2005
Best of All Possible Worlds? Bond Buyers Crave Yield but Show No Fear By FLOYD NORRIS
IN the world bond market, all is sweetness and light. Companies with bad credit do not have to pay very much to borrow, and they have no trouble meeting their obligations. So lenders also do well.
Moody's Investors Service came out with its annual default study this week, finding that just 0.7 percent of companies with rated bonds defaulted last year. That was less than half the rate of 2003 and a fifth of the rate back in the recession year of 2001.
The absence of default reflects the fact that corporate profits are generally in good shape. In 2004, for the first time since 1997, Moody's raised more corporate ratings than it lowered. Companies that need cash have little trouble finding lenders even if their credit is, as the people pitching mortgages on television say, less than perfect.
Consider Warner Music, which Edgar Bronfman Jr. and some financial types bought in a leveraged buyout from Time Warner last March. They put up a little more than $1 billion in equity and borrowed the rest of the $2.6 billion price. Just before the end of the year, the company borrowed $700 million by issuing junk bonds, and used most of the money to repay investors. With that money and an earlier dividend, investors now have taken out nearly every dollar they invested. And they still own a highly leveraged company with talk of an initial offering this year.
Warner Music has done a good job of cutting expenses, and it may be that Time Warner sold out too cheaply. But this would not be possible without a friendly bond market. The junior debt issued last month is rated Caa2 by Moody's, which is nearly as low as you can go.
A few years ago, it would have been difficult to find buyers for such paper. But in 2004 almost 16 percent of new corporate bonds were rated Caa or lower, the highest proportion ever. "They are really bad credits," said Michael Lewitt, the president of Harsh Capital Management, a bond manager. "But people feel they have to get yield somewhere."
Typically most bonds rated that low when they are issued default within a few years. Consider the class of 1998, the last year large quantities of such bonds were sold. More than 40 percent of the bonds defaulted within three years, and by now 74 percent of them have done so.
Those buying low-rated bonds get relatively little extra yield now, because interest rate spreads over high-quality bonds are small. Spreads have been tight before, but not when the overall level of interest rates was as low as it is now. The result is cheap money, which has helped to finance both leveraged buyouts and payments to equity holders. In such cases, the buyers of the junior bonds assume the risks of stockholders, but get limited returns. In the Warner Music deal, the lowest-rated bonds pay no cash interest until they mature in 2014. Owners of the bonds will have nothing to fall back on if things do go wrong.
"Never before," said James Grant, the editor of Grant's Interest Rate Observer, "have junk-bond investors been paid so little for risking so much."
What could end this lovely state of affairs, in which lenders provide cheap money but suffer virtually no losses from bad credits? In 1998, the party was abruptly ended by the Asian financial crisis and the Russian default. No such crisis appears on the horizon now, but forecasting crises is not easy. And low-rated bonds make up 20 percent of outstanding speculative bonds, more than twice the 1998 level.
"This percentage of really risky debt is unprecedented," said David T. Hamilton, the director of corporate bond default research for Moody's. He worries that defaults in coming years could alarm investors and hurt owners of better-quality junk bonds.
But that has yet to occur. Investors crave yield and do not fear risk. Life is good for companies with bad credit.