Junk bond default rates will continue to climb, pushed higher by the large number of low-rated issues that hit the market a year ago, observers say.
"People point to the 1980s as a time of low credit quality in the high- yield market, but the percentage of outstanding bonds at the low end of the credit spectrum is at an all-time high now," according to Martin Fridson, Merrill Lynch & Co.'s chief high-yield strategist.
The default rate for domestic junk bonds hovered at just above 1% in 1996 and 1997. But last year defaults began creeping up from their historically low levels of the mid-1990s, and most market observers say they are likely to go even higher in the near term.
A huge amount of low-rated issuance hit the junk bond market last year. The share of junk bonds unrated or rated B-minus or below was 26% in 1998, compared with 20% in 1985, the nadir for that decade, Mr. Fridson said.
Indeed, the spate of new issuance in the first half of 1998-when issuers churned out a record $150 billion of junk bonds before the market downturn in August-helped keep the annual default rate relatively low.
Defaults as a percentage of principal outstanding averaged 1.6% last year, according to figures compiled for Salomon Smith Barney by Edward I. Altman, a finance professor at New York University's Stern School of Business.
But Mr. Altman said that if the principal amount of outstanding bonds had been more in line with what it was in mid-1997, last year's default rate would have been about 2.25%.
Because bond defaults usually don't occur until two to three years after issuance, Mr. Altman said, he expects the rate to climb to around 3% over the next three years.
Though Mr. Altman's index excludes emerging market bonds, it includes bonds from issuers in other developed nations such as the United Kingdom, Canada, and Australia. But the vast majority of the $465.5 billion of bonds in his index at yearend were from the United States.
The picture is somewhat gloomier on the global junk bond market, in which many U.S. high-yield investors and underwriters participate. Moody's Investors Service Inc. reported the default rate for worldwide junk bonds was 3.75% last year, up from 2.95% the year before. Most of that rise occurred in the second half, after massive defaults in Russia and other developing countries.
"The Moody's default rate is still moderate by historic" standards, said Margaret D. Patel, a high-yield portfolio manager at Third Avenue Funds. "But they are rising from a period of abnormal lows, and the trend is a little upsetting."
Ms. Patel said the relationship between risk and reward is not nearly as favorable for investors now as it was a year ago, prompting them to demand a premium for most junk bonds.
Only well-known companies bringing large, liquid bonds to the market have kept their issue price on the low side. But average spreads have not narrowed as much as some observers had expected since last fall.
The average high-yield spread over comparable Treasuries is about five percentage points now. That is well below the six- to seven-point range of last October when the secondary market was highly illiquid and new issues were scarce. But it is also well below the three-point range during the first half of 1998.
Even with the market offering investors a premium, buy-side interest was relatively modest last month. Coming off the typical January burst of investment, $711 million rolled into high-yield funds the first week of February, according to AMG Data Services.
But then weekly inflows plummeted to $182 million in the second week, $1.2 million in the third, and $69.3 million in the fourth.