By Caroline Salas and Shannon D. Harrington
Jan. 29 (Bloomberg) -- The market for high-yield, high-risk bonds shows that a U.S. recession is a foregone conclusion.
Junk bonds are off to their worst start since 1990, falling 1.8 percent and triggering $17 billion in losses this month, according to index data compiled by New York-based Merrill Lynch & Co. Yields relative to Treasuries are rising at the fastest pace in at least 11 years as prices drop.
The pain may only get worse. Speculative-grade borrowers made up the majority of U.S. corporate debtors for the first time last year, according to Standard & Poor's. The default rate will soar to more than 8 percent this year, the highest since Enron Corp.'s collapse rippled through the market in 2002, estimates Zurich-based UBS AG. Yields show retailers, homebuilders and mortgage companies are among companies at the greatest risk as banks rein in lending.
``You're somewhere between half and 60 percent of the way from the top of the market to the bottom of the market'' if the economy contracts, said Michael Parks, a managing director at Los Angeles-based TCW Group Inc., which manages $148 billion in assets. ``Who wants to put a lot of capital to work there?''
Junk bonds, debt rated below the investment grade threshold of Baa3 at Moody's Investors Service and BBB- at S&P, fell an average of 9 cents on the dollar between March and November 2001, when the National Bureau of Economic Research Inc. in Cambridge, Massachusetts, said the last recession occurred.
$50 Billion Losses
This month they've dropped an average 2 cents on the dollar. An additional 7 cents would create losses of about $50 billion, based on the $709 billion of debt in Merrill's high-yield index.
In a recession, the extra yield investors demand to own junk bonds instead of Treasuries would widen to an average of more than 10 percentage points from about 7 percentage points, said Parks, who wouldn't disclose what he was buying or selling. The spread was a record low of 2.41 percentage points in June.
``The market is saying `We're on the verge of a recession and we may see an incredibly rapid escalation in the default rate,''' said Martin Fridson, chief executive officer of high- yield research firm FridsonVision LLC in New York. ``The floodgates could really open.''
A recession as deep as the one in 1990, which lasted eight months, may push the rate to 16 percent, said Fridson, who previously led a research group at Merrill that won first place for high-yield strategy in Institutional Investor's survey nine years in a row.
Enron Aftermath
The December 2001 failure of Houston-based energy trader Enron was the biggest bankruptcy to date. It sparked an 11.2 percent annualized default rate the following month, according to New York-based Moody's. Spreads reached 11.2 percentage points in October 2002, the highest since at least 1996.
The economy will contract in the first three quarters of this year as a drop in home prices, stock market declines and rising unemployment contribute to ``the worst consumer recession since 1980,'' David Rosenberg, Merrill's chief North America economist, said in a Jan. 22 report. In a Bloomberg survey published Jan. 9, he called for the economy to expand in every quarter.
The subprime crisis is ``just the tip of the iceberg,'' said Wilbur Ross, the billionaire chairman of New York-based WL Ross & Co. who made his fortune buying distressed steel and textile businesses.
`Afraid of Everything'
``For quite a few years, nobody in the credit markets was afraid of anything,'' Ross said in an interview with Bloomberg Television last week. ``Now we're going into a period where they'll be afraid of everything.''
The appetite of investors such as hedge funds enabled even the lowest-rated companies to raise debt financing and avert default last year. Since then, the widening of spreads has enticed buyers such as Matthew Eagan, a money manager at Boston- based Loomis Sayles & Co., who said investors previously weren't being compensated for the risk.
``I'm not trying to be Pollyanna-ish about it, but I'm not as dire as some people are,'' said Eagan, vice president and investment manager at Loomis, which oversees $8 billion in speculative-grade, or junk, debt. ``I think you're getting paid in the market to take on high-yield risk.''
What's different now is that lenders, stung by losses that started with the collapse in the market for mortgage-backed bonds, are wary of financing anyone other than the safest of borrowers. High-yield bond sales fell to $43 billion in the second half of last year from a record $102 billion in the first six months, according to Bloomberg data.
Subprime Fallout
Losses of as much as $400 billion on securities linked to subprime loans may curtail lending by $2 trillion in the next couple of years, Jan Hatzius, chief U.S. economist in New York at Goldman Sachs Group Inc., said in a Nov. 16 report.
Junk ratings were assigned to 51 percent of U.S. corporate borrowers, New York-based S&P said in November. They accounted for 28 percent in 1992. The amount of distressed debt -- bonds that yield more than 10 percentage points above Treasuries --has swelled to $59.3 billion, the most since 2003, Merrill data show.
There are 147 issuers with bonds trading at distressed levels, including Minneapolis-based mortgage lender Residential Capital LLC, whose $16.6 billion of debt was cut to below investment grade last year, and Bon-Ton Stores Inc., the York, Pennsylvania, retailer that had losses in six of the past seven quarters. In November, there were about 60, Bloomberg data show.
At least three high-yield companies have filed for bankruptcy this month. Montreal-based Quebecor World Inc., the second-largest publicly traded printer in North America, and Eagan, Minnesota-based Buffets Holdings Inc., the biggest U.S. operator of buffet-style restaurants, sought protection from creditors last week. Hollywood, Florida-based homebuilder Tousa Inc. filed for bankruptcy today.
``You're pricing in a pace of defaults that is higher than whatever you've seen before.'' said Stephen Antczak, high-yield strategist at UBS in Stamford, Connecticut. ``It's very, very difficult to know what the catalyst is to cause this meltdown to stop.''
