Bonds to Run Away From

Marilyn Cohen, Forbes Magazine, 06.14.99

LOEHMANN'S HAS CRIED "UNCLE" by declaring bankruptcy, a reminder that despite the vibrant economy, it's not easy for every American company today. Without the power to raise prices, companies are being ground down, unless they can eke out productivity gains or cut costs. Not all can. Investors in bonds-from high-quality corporate to junk-should take heed. There are three sectors in particular I would want to keep out of my portfolio.

Retailers: In June 1998 I wrote that off-price clothing retailer Loehmann's was one of the walking dead and recommended selling the company's junk bonds, which were trading at a price of 95. Now the company is reorganizing under Chapter 11 and the bonds are worth 16. Loehmann's won't be the only loser in the sector. The country is overstored and overmalled-and you don't have to be a believer in the Web to see this.

Even investment-grade companies are feeling the squeeze. Two of the more widely held issues are the Sears 9.38% bond due Nov. 1, 2011 and the J.C. Penney 7.38% bond due Aug. 15, 2008. Sears' gross margins have fallen and J.C. Penney has reported four consecutive earnings declines. Penney hopes to sell its credit card business and spin off 20% of its Eckerd drug chain to the public, and then use some of the proceeds to pay down debt (good for bondholders) and some to buy back stock (not good). The bond rating agencies may postpone downgrading Penney, but I think a downgrade will eventually come. If these two giant retailers can't cut it in a great economy, it's time to sell your positions unless you are sure you're going to want to hold them to maturity.

If you want to own a retailer, jump and jive to the merchandising savant Gap (see related story, p. 110). Its noncallable 6.9% issue due Sept. 15, 2007 is A rated by Standard &Poor's and is large ($500 million) and liquid. Priced at 102 to yield 6.5%, it's not exactly a bargain. But in a look-alike retail sector, Gap doesn't.

Steel: Pity the producers. Two old names-Laclede Steel and Acme Metals-went into Chapter 11 last year, after emerging market problems hurt orders and dumping by foreign suppliers generated record imports. This year's first casualty was Geneva Steel.

The time when steel companies could provide a core bond position is over. Of the U.S. steel companies whose bonds are rated by Standard & Poor's, only seven are investment grade, and among these only USX-U.S. Steel Group is an old-line, integrated producer. The widely held USX 6.85% bond due Mar. 1, 2008 is liquid enough (a $400 million issue) and noncallable. Hold if you own it. But priced at 104 to yield 6.2%, its 70-basis-point advantage over the ten-year Treasury is, for new buyers, insufficient compensation for the industry's problems.

The other investment-grade issuers are minimills and makers of specialty steels or finished steel products-okay to buy opportunistically, but not a foundation for anyone's portfolio. Many analysts anticipate firm U.S. construction and auto markets, and therefore higher steel prices. Come on-how much better can the economy get? For now, don't put any more money into the steel sector. If the outlook improves significantly, I'll let you know in a future column.

Health care: Medicare reimbursement has been slashed and many health care providers are in serious condition. Meanwhile, the costs of providing care (drugs and equipment, new facilities) have risen-a recipe for trouble. Onetime investment-grade hospital management companies like Tenet Healthcare and Columbia/HCA Healthcare have been downgraded to junk (both of those are now rated BB+ by S&P), a trend that isn't likely to reverse anytime soon.

Existing junk bonds in the health care sector have been annihilated. The very troubled Vencor recently failed to make a $14.8 million coupon payment; don't be shocked if Sun Health Care Group and MedPartners have similar trouble. Nursing home operators like Genesis Health Ventures, Integrated Health Services and Mariner Health have all been further downgraded.

Even competently managed companies are choking in this poisonous atmosphere for health care. If you own any investment-grade or junk bonds in this sector-I own junk-it's too late to sell without taking painful losses; better to hold and hope for a return to stability. But don't buy.

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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