When Junk Gets Too Junky

Marilyn Cohen, Forbes Magazine, 06.01.98

IT'S AN EBULLIENT MARKET, and not just for stocks. Junk is hot -- maybe a little too hot.

Total return over the last 12 months for the average junk bond fund was 14%. Is this because the issuers are swimming in profits, boosting the credit quality of the bonds and thus their prices? Scarcely. What you are witnessing is the inevitable effect of too much capital chasing too few deals.

Mutual fund investors added $22 billion to the sector in the past year. The flood of new money has pushed down yields and forced bond fund managers to reach for weaker securities to fill out their portfolios. We may not be at a market top for junk bonds, but we certainly are at a point where investors are not getting very good yields for taking on credit risk.

Look at the chart. The junk yield premium (over Treasurys) is less than half what it used to be for BB-rated bonds.

The junk bulls argue that the default rate is a low 2.2% per year and that defaults are rarely accompanied by a 100% loss of principal. Yes, but don't forget that the economy is still hot. In a recession the default rate is going to shoot up. (It was 10.1% in 1990.) The other thing that worries me is that banks that lend to junk companies in the U.S. may be sweeping problems under the rug, much as Japanese banks do for their real estate borrowers. When a junk issuer fails to meet a financial ratio, the bank may look the other way. The issuer stays out of default on its bank loans, and Wall Street can kid itself that the credit is as solid as ever.

I can't quantify the phenomenon of banker forbearance to marginal firms. I do, however, have evidence that junk issuers can deteriorate badly without a collapse in the price of their bonds. Here are three credits that I nominate for membership in the walking-dead society.

Evenflo & Spalding Holdings has a name that sounds solid. If you play golf, you know Spalding and Top-Flite golf balls; if you've recently had a child, you may own an E&S car seat or have fed the baby with an Evenflo bottle.

Acquired by KKR in a leveraged buyout, E&S had $157 million in sales in its first fiscal quarter, ended Dec. 31, 1997. Its debt load includes $200 million in senior subordinated notes, most of a $250 million revolving credit line from banks and $400 million in term loans from banks. The subordinated notes trade at 83, yielding 13.9% to the worst call -- eight percentage points more than Treasurys.

Don't be tempted to buy these bonds. The company's operating income (profits before depreciation, interest and taxes) is barely above interest costs. Meanwhile, Evenflo & Spalding recalled 800,000 infant car seats, has working capital and capital spending requirements, and has principal repayments due later this year on the bank debt. Unless KKR kicks in more equity, this company is headed for a recapitalization in which the subordinated note holders could take a haircut.

Loehmann's is the famous fashion apparel discounter. Its stores are now loaded with ordinary clothes at ordinary prices. The company went public in May 1996 at $17 per share, but has sunk to $4. The 11.875% senior notes, due May 15, 2003, trade at 95, for a 13.3% yield to maturity. In its fiscal year ended in January, Loehmann's was barely covering interest expenses. It may be headed for the remainder rack.

Specialty Foods Acquisition is the holding company for Specialty Food Corp., which makes Mother's Cookies and other snacks. The two companies' debt structure includes $575 million in high-coupon bonds and $319 million (face value) in other debt, such as a bond that starts out with a zero coupon and then steps up to a 13% coupon. For a food vendor with sales that may hit only $1 billion this year, this is a recipe for indigestion. In February 2000 Specialty Foods must begin $40 million in cash interest payments on the step-ups. In August 2001, $225 million in debt principal is due.
It's a good market for issuers, who unloaded $119 billion in new junk bonds last year. It's not a particularly good one for investors.

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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