Junk Rebound Ahead

Marilyn Cohen, Forbes Magazine, 11.13.00

THE HIGH-YIELD MARKET IS IN A SLUMP. Although overall economic growth has been strong up to now, junk bonds aren't. High-yield obligations are like poor people, vulnerable to every economic woe. Hints of a business slowdown hit them hard.

For most of the past decade investors deserted junk in favor of the hotter stock market. Now they are deserting in favor of safer Treasurys.

Defaults are way up, suggesting that a lot of high-yield borrowers took on more debt than they could handle--and even more of them are headed for the deadbeat penalty box. The dean of junk experts, Professor Edward I. Altman of New York University's Stern School of Business, has reported a 2.6% high-yield default rate for the first half of this year, which is a 5.2% rate annualized. That's a mile higher than the 3.2% weighted average annual rate since 1971.

Just as we saw during the last junk debacle, in the early 1990s, a vicious circle is getting going. Banks are frowning upon high-yield issuers. Unhappy result: They now must pay higher interest rates on their revolving lines of credit.

Nevertheless, I think the bottom is near. Even though conditions in the junkyard probably will get worse before they get better--bear markets always do--this is probably the time to take advantage of low prices.

Why? A developing taste for junk by pension funds. Yes, these sober-minded custodians of people's retirement money are traditionally leery of dicey markets. But times are a-changing. With the stock market so volatile and the Treasury supply dwindling because of budget surpluses, the high-priced consultants who advise the funds are now recommending diversifying. Prominent among their alternative-asset suggestions are real estate, limited partnerships and ... high-yield bonds.

The pension plan sponsors are listening. In the past ten months at least 20 pension funds have publicly revealed that they have hired high-yield-bond managers or that they are actively searching for them.

The dollars pouring into the high-yield market from pension plans--public and private--are potentially humongous. Good old-fashioned defined-benefit pension funds, the kind everyone had before 401(k)s were invented, are bulging.

According to Pensions & Investment Age, one of the leading industry magazines, the 200 largest pension funds have $3.7 trillion in assets. We are talking about monster organizations like the California Public Employees Retirement System, General Motors, New York State Common, Texas Teachers and General Electric. In contrast, the U.S. high-yield market is peanut-size. Estimates place its face value at $680 billion.

While I am not suggesting that pension fund sponsors are going to allocate more than 1% to 3% of their kitties to their newly hired high-yield-bond managers--from hardly anything today--that's not chopped liver. Don't forget, 2% of $3.7 trillion, or $74 billion, is material money to the long-ignored and occasionally reviled high-yield market. And that is taking into account only the impact of the 200 biggies.

Importantly, it doesn't take much of a money influx to move junk prices. We know that from the behavior of the market when an institution assembles a $200 million collateralized bond obligation. The simple act of buying $200 million worth of bonds to fund a new CBO puts a temporary floor under the junk-bond market. Imagine then the impact of billions of pension-fund dollars rolling into the market over the next 12 to 18 months.
Because the whole junk market will feel this influx, especially the bigger and more liquid issues, there is no need for you to become an expert in picking bonds. The easiest and most prudent way to get on board is to select a high-yield mutual fund on the Forbes Best Buy list ( see forbes.com ), such as Vanguard High Yield, Fidelity Capital & Income or T. Rowe Price High Yield. Create a game plan to invest an equal amount quarterly and figure you will be fully invested by the third quarter of 2001, when the pension buying is starting to really gear up and we have a bottom in prices.

This wave is going to hit the beach and it will be a whopper. Pension funds are permanent investors; no hot money here. Their critical mass will create the ongoing support the high-yield market desperately needs and a respectable total return--something we haven't seen in a long while.

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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