Junk Bonds Are Still Lurking

Let me guess - record levels of junk bond defaults are positive for the economy going forward?

NEW YORK (Reuters) - About 40 percent of all U.S. junk bonds outstanding in late 2008 will likely default by 2013 as government aid measures end and a wall of corporate debt comes due, Bank of America Merrill Lynch said on Thursday.

By contrast, the cumulative five-year default rate was about 30 percent in the last two default cycles, Bank of America said in a report.

But the real damning part of analysis isn't the front-line - it's the last paragraph:

Many so-called distressed debt exchanges are only postponing defaults and will also contribute to the second wave, the bank said. In a distressed debt exchange, companies buy back debt at steep discounts, usually replacing it with longer-maturity debt. About 40 percent of distressed debt exchanges typically default anyway within three years, the bank said.

No, really? You mean that we can't "extend and pretend" and actually fix anything? It's all a game to try to claim that something that has blown up really hasn't blown up?

Yes, that is what the bank said - this is nothing other than a thinly-disguised game - yet another means of gaming the accounting (which should be illegal, but heh, we don't bother prosecuting stuff like that, right?)

The better question is this: If the economy is healing, if demand is improving, if corporations have seen the bottom and business conditions are in fact improving as final demand is rising, then why are defaults going up?

Debt defaults when the cash flow is inadequate to meet service requirements. But cash flow is a "high frequency" thing - it rises immediately when final demand increases.

So what is this, along with the default rates on credit cards and FHA mortgages telling you?

The claims of final demand improvement are in fact false.

Comments

[Mad Hedge F...:]

bvd At the beginning of the year I was wildly bullish about junk bonds, and recommended a covey of ETF’s, including the Lehman High Yield Bond Fund (JNK), the PS Corporate High Yield Bond Fund (PH, and the iShares iBoxx Fund (HYG) (see my report ). At the time, fears about The End of The World triggered cascading margin calls and distress liquidation that saw tidal waves of paper dumped into a no bid market. Some lesser credits traded with yields at 2,500 basis points over Treasuries. JNK is now 54% up from the March lows, and the others have done as well. Once the Great Depression II was taken off the table, the scramble for yield by hedge funds couldn’t have been more awesome. The average spread over Treasuries has been cut from 1,800 basis points to a mere 1,000, which was where spreads maxed out in the 1990 and 2002 recessions, and could be the new “normal.” This is against a 20 year average junk spread of 600 basis points, and only 100 basis points seen at the ultra frothy 2007 peak. The good news is that falling junk yields may eventually force tight fisted commercial banks to ease up on the supply of conventional loans, which is restraining a real economic recovery. Gains on junk from here may be limited. Emerging market corporate issuers inundated this market in Q2, some dubious borrowers are starting to sneak back in, and the rollover calendar going forward is truly enormous. There are too many better fish to fry. I’d take the money and run.

Sep 18 12:46 PM

[Karl Liesman:]

"Yes, that is what the bank said - this is nothing other than a thinly-disguised game - yet another means of gaming the accounting (which should be illegal, but heh, we don't bother prosecuting stuff like that, right?)"

Karl, creditors are taking it upon themselves to extend risk to these risky enterprises. Who is gaming what when it is up to those creditors to hand over long maturing debt in exchange for current debt? Why would it be illegal for a business to attempt to stay in business longer by reorganizing their debt? Do you understand how debt actually works?

Also, it is interesting that you ignored the following upward revision in BAC's default rate estimate from 17% to 12.8%. Who is to say that this won't be revised again in the future?

"Bank of America in December had forecast that the junk bond default rate could peak at 17 percent in the second quarter of 2010, the worst since the Great Depression. Thanks to numerous government lifelines, including near-zero interest rates, it now expects the default rate to peak at 12.8 percent in the fourth quarter this year."

Can you answer these questions?

Sep 18 01:12 PM

[Mark Anthony:]

Karl:

You are wasting your time.

The article you quoted is nothing but merely one never heard about journalist's biased report of the OPINION of one un-named analysts, out of thousands of analysts who work for just one of the nation's major banks, Bank of America. How many levels of indirect are we talking about here?

And you are treating that as a Physical FACT, and try to derive some conclusion by analysing that "FACT"? Do you realize that 2013 hasn't happen yet so whatever happens in 2013 is nothing but any one's guess.

Your articles have reaches a new low. Which one of your recent articles have helped folks to pick up a good stock and make money recently? Your "short the phone book" recommendation? Please admit now that your deflational picture is deadly wrong.

Sep 19 11:20 AM

[Karl Liesman:]

Mark,

Great questions for Karl. Karl, please answer because posting on seekingAlpha is different than posting on your own blog. There is a standard of credibility that should be upheld here. Do you have that credibility? If you feel you do, can you answer these questions?

[Please see editorial comment below.]

Sep 19 12:36 PM

[artkarl:]

I don't understand why the commentary all seems to be from illiterates.
Does no one read beyond the CNBC front page?

It's clear that a nation that actually produces less and less, whose "smart" people all channel into Wall Street to fabricate dollars thru ever more arcane "instruments", is on the ultimate rail for the lizard.

I would say Mr. Denninger has answered all the pertinent questions, and I look forward to his continued commentary.

Sep 19 02:04 PM

[Tack:]

The implication that there's something "wrong" about companies in an open market being able to buy back debt, extend maturities and/or refinance rollover debt is a curious position. Would it be more reasonable that all debts be called in and credit completely cancelled?

In fact, if companies (and individuals) were precluded from rolling their debts forward, especially in contracted economic periods, we would see exactly the kind of deflationary economic implosion that private enterprises and governments so assiduously try to avoid. Such an outcome would benefit no one, not even creditors.

Sep 20 04:01 AM

[Ferdinand E...:]

Really terrible about these "junk bonds", ain't it?. Of course, I call them the same thing that Michael Milken called them, i.e. high risk bonds, and if people want to buy them - especially higher grade junk - that's their business. Incidentally, just for the record, Michael Milken never stole anything, and his sentencing was a travesty of justice.

Sep 20 08:42 AM

[Wisdom vs. ...:]

i follow over 40 stocks. almost all of them had much better cash flow in the second quarter. CIT and GECap are more immendiately exposed to cash flow problems than anyone, just watch them if you really want a good overview. high risk bonds are always lurking, and the statement that extending loans needs to be prosecuted is ridiculous

Sep 20 12:05 PM

[SA Editor M...:]

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Sep 29 11:56 PM