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Study reveals 35% rise in junk bond risk
Source: Financial Times
Date: June 25, 2003
Author: Gary Silverman
A new study (PDF/896KB) raises serious questions about the rally in high-yield bonds, suggesting the credit quality of junk-rated US companies is lower than last year.
Moody's KMV, a risk-measurement company, said the probability of default by such companies was about 35 per cent higher than last year.
The finding contrasts with activity in the markets, where investors have signalled they are growing more confident in the quality of sub-investment grade debt.
"Default risks have come off extreme levels, but they remain pretty high in parts of our default universe," said Tim Kasta, managing director of Moody's KMV in San Francisco.
Junk bonds have staged a powerful rally in recent months, with the price paid for such paper soaring from a face value of 78 cents on the dollar last October to about 99 cents in recent days, according to Merrill Lynch.
The spread between interest rates on high-yield bonds and 10-year Treasuries - an indicator of investor confidence in junk bond issuers - had narrowed from 7.34 percentage points last June and 10.15 percentage points in October, to 5.56 percentage points last week, Merrill said.
Moody's KMV said its risk measure - which it calls the median expected default frequency - had improved significantly for sub-investment grade companies since October, suggesting the junk bond rally had an economic foundation.
However, the Moody's KMV study also supports the view that high-yield investors have recently become over-optimistic - a frequently voiced concern.
Mr Kasta said the median default probability for junk-rated companies in the US was 2.62 per cent at the end of last week, compared with 1.94 per cent at the same time last year. It measures the risk of payment default within a given period, usually one year. The calculations reflect market values and volatility, as well as corporate leverage.
The higher probability of default suggests spreads between junk bonds and Treasuries should be wider than last year, reflecting the greater credit risk.
Copyright: The Financial Times Limited 2003
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