Junk bonds signal defaults may bottom soon
NEW YORK (Reuters) - Junk bonds are signaling that the worst of a U.S. default wave may be over in as little as three months, though for junk bond investors, a recent rally may be as good as it gets.
After government repair work to the financial system encouraged risk-taking, junk, or high-yield bonds rallied hard in the first half, returning 28 percent through Tuesday and more than erasing last year's record losses, according to Bank of America Merrill Lynch data.
Given how far junk bonds have come and the lingering risks in the economy, it will be hard for the market to rally much further, however, strategists said.
"Technically speaking, you can make an argument for a fairly soft four to five months in front of us," said Christopher Garman, founder of Garman Research in Orinda, California.
Seasonal patterns are one factor that could curb further gains, since high-yield bonds typically have their best performance in the first half of the year, Garman said.
Moreover, junk bonds are no longer cheap now that bargains created by last year's financial panic have been snapped up, strategists said.
MORGAN STANLEY URGES CAUTION
"Given a tepid economic recovery at best, with much to prove and a lot to lose, we recommend remaining defensive," Morgan Stanley said in a recent report.
Junk bonds, those issued by riskier companies, have long been a bellwether for default and economic trends. Their spreads, or the extra yields they pay over Treasuries, tend to rise ahead of a climb in defaults and narrow as default risks fall.
As the credit crisis came to a boil last summer, junk and even many investment-grade bond spreads widened to "distressed" levels of more than 10 percentage points over Treasuries, foreshadowing mega-defaults by Lehman Brothers (LEHMQ.PK), Washington Mutual (WAMUQ.PK), Tribune Co (TRBCQ.PK) and others.
After peaking at nearly 22 percentage points in December, junk bond spreads have since declined by half to about 11 percentage points, still in distressed territory but at least not pointing to a Depression-style bankruptcy wave.
Spreads are now signaling that defaults will likely peak at about 12 percent around September, according to Garman. That would be just one percentage point higher than their 2002 peak during the last bankruptcy cycle and well under the record 16 percent in 1933.
The default cycle has already been brutal for U.S. companies and investors. About $356 billion of bonds and loans have defaulted since the recession began in January 2008, according to Moody's Investors Service.
CASH MAY PROP MARKET
What is worrisome for strategists is that the economic recovery is likely to be weak, keeping business conditions fragile and defaults above average long after they peak.
Moody's is forecasting a peak U.S. default rate of 13.5 percent in the fourth quarter. The rating agency expects the default rate to decline sharply after that but to remain above its long-term average of 5 percent for at least the next year.
"There certainly remains the risk that spreads could reverse themselves or access to debt markets could become more difficult, and that could keep some upward pressure on default rates," said Kenneth Emery, head of default research for Moody's. "The default rate going forward is very contingent on to what degree the economic recovery, if we have one, takes hold and how strong it's going to be."
But the economic picture is not the only driver of defaults. Cash pouring into junk bond mutual funds, totaling nearly $20 billion year to date, according to AMG Data Services, could help some companies finance themselves out of trouble and keep the rally from reversing too much, strategists said.
"Strong high-yield (cash) inflows have undoubtedly fueled this rally and could continue to cause spreads to tighten," Morgan Stanley said in its recent report.
(Editing by James Dalgleish)
