Junk Bonds Give Investors the Jitters

JUNK-BOND jitters have returned to United States financial markets. This was underscored by a 27.74 point market drop in the Dow Jones industrial average Sept. 13. The 1 percent drop in the Dow in part reflected concerns about possible defaults on some popular junk-bond issues.

More than $200 billion worth of junk bonds are outstanding. Junk bonds are high-risk speculative bonds (usually issued by corporations) that have especially low credit ratings. Paying higher yields than quality-grade bonds to induce buyers, they have been used to finance much of the corporate takeover/merger fervor of recent years. But junk-bond holders are concerned that in the event of a downturn - either a recession or a significant slowing of the economy - the companies issuing the bonds would not be able to meet interest payments, causing the value (price) of the bonds to fall sharply.

There is a growing perception that even without a recession junk bonds will not be as valuable an investment instrument in the future in relation to competing vehicles, such as US Treasury instruments or higher-grade corporate bonds.

``Due caution is warranted for junk bonds,'' says John Lonski, senior economist for Moody's Investors Services. ``We're seeing a substantial slippage in corporate credit quality, which means downward pressure on junk bonds.''

The plunge in junk-bond prices last week was kicked off by the troubles of Campeau Corporation, the big Canadian real-estate concern that used junk bonds in financing the purchase of Allied Stores Corporation and Federated Department Stores Inc.

Mr. Lonski notes that Moody's now rates some $210 billion worth of bonds as Ba or lower. ``That's nearly 10 times the amount ... back in 1981, when the junk-bond market was just getting under way,'' Lonski says. In December 1981 - just as the nation was emerging from a deep recession - there were some $23.5 billion worth of bonds with the lower rating.

For the year to date, according to an analysis published last week by Moody's, ``quality bonds still hold a substantial lead in terms of total return.'' Total return is the income from a bond's coupon, plus any price change in the bond. Long-term Treasuries, says Lonski, have provided an 11.9 percent total return; investment-grade corporates have provided an 11.6 percent return. Even three-month Treasury bills, with their government-guaranteed, risk-free nature, have returned about 5.8 percent. High-risk junks, by contrast - which have no built-in safety factor - have only returned 6.8 percent.

Lonski notes that so far this year Moody's has downgraded some 104 speculative-grade issues, compared to the 110 speculative downgrades for all of last year. There have already been 46 rating downgrades to Caa or lower in 1989, the bottom rung of the credit ladder, compared to 50 for all of last year.

Nor Lonski adds, is the ``upside'' of the equation any better. That is, there have been very few upgrades - junk bonds issued at low grades and subsequently upgraded to a higher credit rating. Last year there were 73 upgrades noted by Moody's; this year only 37.

Not all analysts, of course, are wringing their hands over the future direction of junk bonds. ``In general, if you look at the total universe of junk bonds, we just don't perceive junk bonds to be a bad investment,'' says Christopher Probyn, an economist with DRI-McGraw Hill, an economic consulting firm in Lexington, Mass.

That doesn't mean, says Mr. Probyn, that one shouldn't be careful when investing in junk-grade bonds. That's necessary, given the speculative nature of the bonds, says Probyn. ``But what one needs to do is to be very diversified in terms of junk bonds. In terms of total return, junk bonds remain an acceptable investment vehicle,'' he says.

DRI does not believe that the default rate on junk bonds would be especially high, even in a recession, Probyn adds.