Junkyard Armor

Marilyn Cohen, Forbes Magazine, 02.07.00

AT FIRST GLANCE THE ARGUMENTS ARE compelling for owning junk bonds. With the economy enjoying low inflation and good growth, they're an attractive alternative to stocks and command wide spreads to comparable Treasurys. Of course, the usually double-digit yields are a huge selling point.

But many investors are now discovering, to their horror, that the junkyard is a treacherous place. Credit quality is deteriorating, banks are getting tough on terms, especially for companies in violation of their loan covenants, and defaults are on a worrisome increase. Moody's trailing 12-month default rate went from 3.4% in 1998 to a five-year high of 5.5% last year.

So if you're sitting with a bond gone bad, or about to go bad, know how to protect yourself. Here's some advice on holding down your losses.

What do you do when a default seems imminent? Sell if you can find a bid. Remember, though, that liquidity is poor for troubled bonds. Should you find a buyer, be sure to check on whether the buyer is planning to pay you for the accrued interest, the normal procedure for any high-grade bond. On a 9% coupon junk bond four months from its last interest payment, the accrued interest is as good as three points on the price. When the buyer does not pay the seller for accrued interest, the bond is said to trade "flat." This is the customary procedure for any bond already in default.

What if the issuer is not yet in default but heading there fast? Negotiate.

One strategy is to sell a shaky bond with a "due bill." Have your broker stipulate this on the sale confirmation statement. A due-bill designation means you get your proportionate share of the next interest payment, if there is one. Busted-bond buyers are normally arbitragers who want to build big positions in restructuring or bankrupt companies; they don't care about interest. You'll earn a little less on the sale, but the final coupon may well be worth it.

What if buyers won't go for a due-bill arrangement? Should you believe there's at least one more fat interest payment that the limping issuer will make, you might want to delay a sale. I know of a father and son who each owned the Service Merchandise 9% bond due Dec. 15, 2004. The jewelry retailer then announced it would miss the Dec. 15, 1998 interest payment. The son sold on the news; Dad held on.

Dad came out ahead. During the 30-day "curing" period, when a company can pay up and avoid default, Service Merchandise found the money and paid the coupon. Junior was out of luck. Dad then bailed out before Service Merchandise declared bankruptcy in March.

Haggling pays in the junk business. In the bond market rout in the fall of 1998, rumors that Contifinancial, a finance company, was finished, knocked down the price of its 8.4% bonds due Aug. 15, 2003 to 17 cents on the dollar. Nevertheless, if you looked, there were investors willing to pay more, betting that interest payments would continue. Price: 24 cents on the dollar. Sure enough, a year later, the company was still hobbling along, paying interest.

Looking to buy bad-news junk? Be very careful of "overfunded" bonds, which can lull you into a misplaced sense of security. These are issues that find a market at issuance by offering a safety guarantee: escrowing part of the proceeds in a fund to meet interest payments until the business can generate operating income to pay the interest.

A good example is Optel, a provider of communication services, which filed for bankruptcy on Oct. 28, 1999. Optel's 13% bonds due Feb. 15, 2005 had enough in the overfunded kitty when they were issued in 1997 to pay interest for three years. Optel's escrow fund should pay interest accrued through the filing date. After that, bondholders will be standing in line with general creditors, praying.

Another warning: Don't assume that, just because a company paid the coupon on one issue, it will pay the coupon on them all. Take Integrated Health, a nursing home operator that has run into a crunch (see my June 14 column). The company paid interest in September on its 9.5% bonds due Sept. 15, 2007. In October, though, it missed payment on the 10.25% bonds due Apr. 30, 2006.

Buying troubled bonds is a risky game that most should avoid. A bond with a 10% coupon trading for 50 cents on the dollar seems to offer a 20% yield. But if the issuer goes bust a year later and settles for 25 cents on the dollar, you won't even make back your principal.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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