[Mb-civic] Buttonwood Down at the dog pound

Wed Nov 10 14:50:45 PST 2004

Buttonwood 

Down at the dog pound

Nov 9th 2004 
>From The Economist Global Agenda

Why are so many investors prepared to lend to lowly rated companies at
dangerously thin rates of interest?

WHAT, Buttonwood wonders, is the world¹s most expensive security? He finds
many an investment eminently resistable on account of its being exorbitantly
pricey. The list includes, inter alia, most technology stocks, many of their
less whizzy counterparts, ten-year Japanese government bonds yielding 1.5%,
and houses in London. But there is at least some sort of future in which he
could imagine that buyers of these might not lose a packet. It is, however,
hard to imagine a future in which anyone will do anything but lose their
shirts from buying the 10% bond maturing in 2012 issued by the Mueller
Group, which does something widgety with pipes.

The bonds are subordinated, which means that in the event of default, the
holders rank lower than other creditors, of which there are many because the
company borrows so much. The bonds carry a lowly rating of Caa1 from
Moody¹s, a big rating agency. In March, Moody¹s downgraded the company after
becoming concerned about a big debt issue that it would use to pay $396m to
DLJ Merchant Banking Partners, a private-equity firm that held 94% of the
stock of the holding company. Loading up with debt to pay holders of company
stock is the sort of thing that unnerves bond investors, who receive only
the coupon (ie, interest).

Or it should do. In fact, the price of the Mueller 10% 2012 has soared. The
bonds are now trading at a price of about $108 for every $100 of bonds,
giving them a yield to maturity of 8.15%. Since they were issued at ³par²,
or face value, only in April, they have, it is clear, proved a particularly
toothsome investment. Having risen so much already, are they still a good
buy? Michael Lewitt of Harch Capital Management, a hedge fund that
specialises in selling short expensive bonds, in the hope of buying them
back cheaper, thinks not. Mueller¹s bonds are but one of a bucketful of
lowly rated names that he heartily dislikes (and is thus short of) because
they are so expensive. Life has been tough of late for Mr Lewitt, because
the market is chock-a-block with bonds of jaw-dropping expensiveness that,
in recent weeks, instead of getting cheaper, have instead flown off
stockbrokers¹ shelves.

 So there is, it is clear, a school of investors that thinks such bonds are
still cheap. Buttonwood can¹t help but feel they should have done a class in
finance. There are, it is true, good reasons why junk bonds should have
become more expensive than they were in, say, the autumn of 2002, when the
interest-rate ³spread² on junk over Treasuries reached ten percentage points
or thereabouts (the number is pretty meaningless because there wasn¹t any
trading to speak of). Since then, the nightmares about the financial health
of corporate America have disappeared as the economy has been bathed in
sunlight, profits have risen and companies have apparently become sharply
less indebted. Junk-bond defaults have fallen from a peak of 10.5% of all
issuers in the year to March 2002, to 2.3%.

These are the respectable reasons for bidding up the price of junk. The bad
reason is that it offers a sniff of yield in a world where returns are hard
to come by. It is a bad reason because the good folks that are snapping up
the bonds at their current derisory yield are not being rewarded for the
risks they are taking.

When you buy a corporate bond, you buy, in essence, the risk-free rate
(Treasuries) plus something extra to compensate for the risk that you won¹t
get your money back. The higher the risk that the company won¹t repay, the
more that any sensible investor should demand in compensation for lending to
it. Investors might get a bit of extra oomph from their investment were
their borrowers to get upgraded, but the downside for buyers of corporate
debt is generally much greater than the upside, compared with equities: you
get the money back plus a bit of interest if you¹re lucky, and if you¹re
unlucky you don¹t.

The dodgier the issuer, the more it has risen. The highest-flying markets in
recent weeks have been for bonds issued by the least creditworthy companies:
those rated B and lower. (For comparison, the highest is AAA and D stands
for default.) The Merrill Lynch index of B-rated corporate bonds now yields
7.4%‹a quarter of a point less than a month ago, even though Treasury-bond
yields are higher.

 Just how unlikely investors are to get their money back can be gauged by
the default statistics that the rating agencies produce. According to
Standard & Poor¹s, another big rating agency, a bit more than 13% of issuers
with a rating of B- or less will default within a year, and 39% of them
within five years. For those with a rating of CCC (roughly, its equivalent
of Caa1, Moody¹s rating for Mueller) the figures are 30% and 53%. According
to Standard & Poor¹s, 85% of junk bonds issued so far this year have a
maturity of more than seven years. Chances are, in other words, that anyone
hanging on to such bonds until maturity will not get their money back.

Some investors might think they have a better chance of being repaid than
those numbers suggest, because of the decline in defaults. But Standard &
Poor¹s points out that when issuance of bonds with a rating of B- or lower
exceeds 30% of total junk-bond issuance for any length of time, defaults
pick up within a couple of years. So far this year, the figure is about 40%.
Issuance of CCC bonds accounts for some 12% of junk issuance. That should
surprise no one: supply has risen to meet demand. What self-respecting
finance director would shun an opportunity to issue extraordinarily cheap
debt to eager punters? At some point, however, the cycle will turn, the
economy will slow, defaults will rise, appetite for risky bonds at
suicidally thin spreads will evaporate, and investors will wish they had
visited Crufts, not the local dog pound.

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