Credit Markets Dip Into Absurdity

To judge from the crystal ball of debt markets, next year will bring some incredible calamity, maybe a depression, maybe worse. Bond prices suggest that nearly one in five companies with high-yield debt could slip into bankruptcy. The average prices for certain loans have dropped to 70 cents on the dollar, what they usually fetch in bankruptcy. The differences between corporate bonds and Treasurys now stretch beyond some investors' beliefs.

"Spreads are more than ridiculous," said David Kotok, chairman of Cumberland Advisors in Vineland, N.J. "Either we have dysfunctional credit markets evidenced by absurd pricing, or the market pricing is accurately forecasting the Great Depression of 2009, '10, '11, '12 and '13." 

With three-quarters of high-yield bonds trading at distressed levels, the market implies a one-year default rate of 18.5%, according to Garman Research. That's worse than most expectations and higher than previous peaks of 13% in 1991 and 11.5% in 2002. Standard & Poor's forecasts a 7.6% default rate in a year from now. The rating agency's worst-case scenario has the default rate hitting 9.6% at the end of 2009.

Most bond market participants blame a flood of forced sales as hedge funds, mutual funds and trading desks unload assets to meet margin calls and return cash to unhappy clients, rather than approaching an apocalypse. Investors pulled $39 billion from taxable bond funds from mid-September to Oct. 31. Hedge funds lost a record $30 billion in September--2% of assets. October was likely worse. The result is that many trading desks send out reckless bid lists instead of making orderly sales.

Since Lehman Brothers (nyse: LEHMQ - news - people ) filed for bankruptcy on Sep.15, bond market buyers have remained spooked. High-yield loans have dropped from 89 cents on the dollar to 71 cents on Nov. 7, according to Standard & Poor's. In the same period, corporate bonds have fallen from 93 cents on the dollar to 79 cents. Junk bonds now yield 14 percentage points over Treasurys. "Clearly, at those spreads, there is fear in the market," said Diane Vazza, head of fixed income research at S&P.

Once all this forced selling finishes, bond markets should begin to improve and companies may again find they can sell debt at reasonable rates. Still, there's another problem. Many large players in the fixed-income market, such as collateralized loan obligations and Lehman Brothers, no longer exist.

"A lot of the buy side has just disappeared," said Mike McGonigle, head of fixed-income research at T. Rowe Price.