Some junk bond issuers are not as creditworthy as they were a year ago, according to two major rating agencies.
In a dramatic reversal, Standard & Poor's downgraded 109 industrial high-yield issuers in the second half of 1998, while upgrading only 23. In the first half of the year it downgraded 59 issuers and upgraded 86.
Moody's Investors Services has also been taking a dimmer view of some junk issuers since the high-yield market skidded out of favor in August. It reported that downgrades on junk bonds were twice as common as upgrades last year.
"I think the rise in 144a issuance has been pushing the general level of quality down," said M.G. Subas, a Moody's managing director and co-head of high-yield research.
The 144a regulations allow junk bonds to be sold privately without registering with the Securities Exchange Commission. Rule 144a bonds now make up about two-thirds of domestic junk bond issuance.
The high-yield market has been going like gangbusters for most of the 1990s, with more than $150 billion worth of new issues recorded in 1998. Though high-yield investors are usually compensating for risk with a somewhat higher return on investment, the risk of default has been low for much of the decade.
But Mr. Subas said default rates are rising, with 52 U.S.-based companies defaulting on junk bonds last year. It is unclear how many defaulted in 1997.
The U.S. high-yield market is so vast-thousands of companies have outstanding junk bonds-that the number of defaults seems minuscule, according to bankers who underwrite the issues.
"Of course, if a company is downgraded, their bonds will take a hit," one banker said. "But the market is much too large for a few downgrades to have a broad-based effect." The banker also pointed out that many of the bonds that have been downgraded are small in dollar value.
In the fourth quarter, S&P reported 66 downgrades and 22 upgrades. But when viewed by dollar volume, upgrades carried the day: Bonds worth $19.5 billion were downgraded, and bonds worth $40.4 billion were upgraded.
That is because most of the bonds downgraded by the agency were in the $100 million to $300 million range. Junk bond investors have been somewhat unreceptive to smaller issues from low-profile companies since the stock market dipped six months ago.
A few sectors have been particularly hard hit, according to Nick Riccio, S&P's managing director in high-yield.
The U.S. energy industry has suffered from the decline in demand due to economic crises in developing nations, he said. The direction of the U.S. health-care industry is also widely questioned, he added.
He said the rating agency was roughly four times more likely to downgrade an energy junk bond issuer than upgrade it last year, and roughly five times more likely to downgrade a health-care issuer.
But some of the bonds that have been downgraded in recent months might never have priced if it had not been for the strong investor appetite last year.
"There is no question that some marginal deals were done in last year's strong market because so much money was in the system," said Harry Resis, a high-yield portfolio manager with Scudder Kemper.
Mr. Resis said investors need to examine credits more cautiously when rating agencies step up the number of downgrades. But, he added, that is no reason to back off from a market.
"Many times these downgrades were anticipated," he said. "Rating agencies are looking backward when they make a downgrade, and we have to look forward and guess where the company might be heading."
But Moody's Mr. Subas said the downgrades put more stress on the market environment.
"You have less pricing flexibility if the market encounters unforeseen shocks," he said.