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Investor pain likely to intensify over the next 12 months: Fewer defaults but bigger hits for bonds
Source: Investment News
Date: December 9, 2002
Author: David Hoffman
The projected rate of bond defaults has lessened somewhat, but the bite a busted bond could put on your bottom line may be more painful than ever.
So says Tim Kasta, managing director of Moody's KMV, a division of Moody's Corp. in New York. Mr. Kasta says his San Francisco-based outfit expects losses over the next 12 months to be about 66% of principal, on average, for senior unsecured bonds of U.S. industrial companies.
The percentage changes depending on the type of bond and the type of company, but they are all pretty bleak, he says. A decade ago, such losses amounted to about 40% of principal.
That could mean trouble for portfolio managers. They could face larger-than-expected losses if a bond they are holding blows up. Not everyone, however, agrees.
Don DeVeuve, a senior vice president with State Street Research and Management Co. in Boston and co-head of its high-yield-sector team, agrees that investors are currently facing historically high losses on defaulted bonds.
But those losses are inflated thanks to the fall of companies such as WorldCom Inc. and Enron Corp., he contends. Their spectacular blowups pushed the entire market down, he says.
"It's been an extraordinarily bad year," Mr. De-Veuve says. "I would expect the loss an investor would take on a [busted bond] to improve."
After all, Moody's KMV's own numbers show that it expects the rate of companies defaulting on their bonds will be less than what it projected for the rolling 12-month period beginning in September. Mr. Kasta says his firm calculated a 7% default rate for that period but last week predicted a 5% rate over the next 12 months. In other words, Moody's KMV predicts that one of every 20 public companies in the nation will default next year.
Brooks Brady, an associate director with Standard & Poor's in New York, says those numbers are in line with what his firm sees happening next year.
A 5% default rate is still historically higher than what the market usually sees, Mr. Kasta says. But that doesn't explain why the losses an investor should expect to take on a defaulted bond will remain at what Moody's KMV says will be at an all-time high.
The loss an investor should expect on busted bonds is actually calculated by Moody's KMV's LossCalc system. It incorporates macroeconomic, industry- and company-specific information, and expense data, to estimate how much a creditor will lose if a company defaults.
Mr. Kasta says he is still trying to determine why the system is predicting such high losses, but he can make an educated guess.
In a high-default environment, the value of a company's assets is low, he says. When everyone's assets are falling, there's less money to pay back the creditors if the company defaults on its bonds.
G. David MacEwen, chief investment officer, fixed income, and a senior vice president with American Century Investments in Kansas City, Mo., says there may be another explanation. Many of the companies that have defaulted or are in danger of defaulting on their bonds are New Economy companies that may lack the assets to repay investors.
Mr. Kasta says it creates a sticky situation for portfolio managers. Those portfolios that are poorly diversified will continue to see large losses, he says.
Mr. MacEwen, however, says portfolio managers shouldn't be afraid to invest in corporate bonds, particularly high-yield bonds, which he believes will fare the best in the coming months.
While it's true that high-yield bonds are the ones that are most at risk for default, it should be remembered that the projected default rate has declined. Since high-yield bonds will be the ones to benefit most when the economy recovers, it makes sense to begin looking at them, he says.
Mr. DeVeuve of State Street Research agrees somewhat but says he would stay out of the truly depressed credits. There's still a lot of "intense" competition among companies whose bonds fall into the junk category, and some may not have gotten past the problems that pulled them down in the first place.
That is all the more reason to jettison the buy-and-hold strategy, Mr. Kasta says. An investor who wants to get into the junk-bond market should be willing to get rid of bonds as soon as it becomes apparent that they're candidates for default, he says.
"In today's economic environment, investors need to be very active," he says. "Buy, hold, sell needs to become the daily activity of the portfolio manager."
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