Two Faces of Junk

Marilyn Cohen, Forbes Magazine, 11.10.03

Fallen angels, bonds that have slipped from investment-grade grace, are a fine way to get yield. But you have to be careful. Not all of them are worth the risk.

Lately Moody's and Standard & Poor's have been cutting corporate bond ratings by multiple notches, which has slammed prices. A number of bonds with famous names have been put on the junk pile by one or more of the rating agencies: Interpublic Group, Smithfield Foods, Tyco, Avnet and Tenet Healthcare, to name a few.

These blue chip has-beens are what Wall Street calls "fallen angels." Having issued debt of investment-grade credit quality, which means a BBB or better, they fell victim to economic hard times, overambitious and inane acquisitions, balance sheet bloat or poor business execution.

Some angels are destined to be resurrected. With interest rates at less than tantalizing yields, it's time to sort through the discredited names and establish some very selective holdings. But don't let your hunger for yield make you overlook important fundamentals.

Two kinds of issuers to avoid:

Asbestos-linked businesses. Sixty companies have filed for Chapter 11 bankruptcy to fend off asbestos claims. This problem recently whacked Union Carbide bonds, amid signs that its parent, Dow Chemical, would do nothing to bail out the subsidiary. In early September Moody's downgraded Union Carbide bonds five notches from Baa2 to B1. That sent prices tumbling 10 to 20 points, or $100 to $200 for every $1,000 of face value.

Investigation targets. If the Securities & Exchange Commission or any other official types are scrutinizing a company for civil or criminal misdeeds, don't get involved. Why ask for trouble? Tenet Healthcare, for example. Who knows what the litigation price tag and settlement will be as Tenet fights allegations of overbillings, unnecessary surgeries and physician kickbacks? And although the tobacco companies have settled the major suits from the state attorneys general, new plaintiffs keep popping up and adding more zeros to their legal costs.

As of mid-October there were 30 issues on Standard & Poor's Global Fixed-Income Research potential fallen-angel list, totaling $31 billion in face value. The names are concentrated in high technology, insurance and utilities. The good news is that fewer are falling these days: At the same point in 2002, 52 were on their list, with par of $69 billion, suggesting that business conditions are getting better.

While fewer newly fallen angels are available lately, the numbers suggest that they stand a better chance of recovery. Not only will better economic times help them, but also their average debt burden is lighter than that of comparably discredited borrowers in the past. With junk defaults easing, odds are that the angels' prices have seen their low points. The ones I like, in fact, are selling at a premium--and are worth every penny. Their coupons are high enough that they comfortably outyield comparable Treasurys and investment-grade corporates.

While you should be skeptical about a lot of junk out there (see my July 21 column), the bonds most likely to add value to your portfolio are from companies that have made strides in strengthening their balance sheets and cutting costs. To reduce the risk, stick to short- and medium-term maturities.

Among the names I like is Avnet, a semiconductor and computer products distributor. The tech downturn over the past several years has killed its profits and thus its interest coverage--a key measure of debt-servicing ability defined as the ratio of earnings before interest and taxes to interest expense. With a little luck and a tech-spending rebound, Avnet will be in fine shape to repay its lenders. The Avnet 7.875s due Feb. 15, 2005 are trading near 103 to yield 5.5% to maturity, which is 3.5 percentage points more than the two-year Treasury note.

Another good choice is the Bausch & Lomb 6.95s due Nov. 15, 2007, priced at 106.25 for a 5.2% yield to maturity. One year ago Bausch & Lomb had liquidity and balance-sheet problems. During the summer the company successfully managed to restructure its debt and greatly improve its cash flow.

Starwood Hotels owns, manages and franchises hotels worldwide, mostly under the Westin and Sheraton brands. Management has sold assets to reduce debt, improving the balance sheet markedly; with a weensy recovery in lodging demand, this company is poised to recover. The Starwood 7.875s due May 1, 2012 trade around 109.50 for a 6.4% yield to maturity.

So buy a few fallen angels. As always, if you buy any junk bonds to juice up your portfolio, buy more than one; diversification is vital in this risky kind of investing. These picks may not go back to investment grade anytime soon, but they pay well enough that it doesn't matter.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.

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