In this present economy we’re enduring, with our government in a state of economic turmoil, financial bailouts in process and sheer bedlam prevailing in our society, we citizens should be more vigilant than ever on where we have invested our money.
I just received my issue of Forbes magazine and a financial article by Richard Lehmann titled “Bond Default Wave”, piqued my interest immediately as a great majority of people have fixed-income (classified as stable) investments in bonds. Any alarm concerning the welfare and safety of these investments dictate that I immediately share it with you. Here it is and I’ll paraphrase it for you along with my objective commentary.
Lehmann’s business has maintained a database of all corporate and municipal bond defaults since l982. With the passage of time it has grown and included defaults by 4,400 issuers on $560 billion in debt. This is a major concern for investors, even if defaults have been relatively few in the last few years.
The reason to worry right now is because corporate bond defaults come in waves, not a continuous stream. They happen when banks cut off companies’ lines of credit, and that usually occurs when there’s a recession, i.e., the economic downturn reduces the value of a company’s assets and thus reduces the collateral that banks can fall back on to recover loan principal.
Now, we are facing not only recession but also a banking industry with damaged balance sheets of its own. Throw in the fact that the corporate junk bond market has grown to $ l.3 trillion and you have the likelihood of defaults easily surpassing the last wave in 200l-02. In 2002, $98 billion of corporate bonds went bad, out of $757 billion outstanding.”
One of the effects of such a default wave is that it makes a recession last longer, keeping more bad news on a market, whose faith in credit ratings is already impaired. That’s a danger right now, as even investment-grade issuers are having to pay 8 percent or more for their borrowings. Such yields suggest that we may face some significant defaults even among bonds with ratings above the junk level.
What about tax-exempt bonds? You might presume that municipal bonds aren’t vulnerable to default, but they, too, fail in significant numbers. In fact, of the 4400 defaults in the database, 2900 are of municipal bonds.
Their total principal amount of $445 billion is low compared with that of corporate defaulters, as the typical municipal issue (especially revenue bonds, which are most prone to default) is much smaller than a corporate one. Insurers, including the federal government, made good on the loss of 30 percent of that default volume. In those cases, muni insurance was really worth something.
The causes of municipal bond defaults are many: nursing homes don’t fill up, housing developments that were started too late, commercial projects with thin revenue streams and so-called “economic development” tax exemptions.
This year we’ve seen an unsurprising surge in defaults connected with housing developments in
The good news about bond defaults, however, such as it is, is that when they do happen, all is usually not lost. Bond holders have a claim on a company’s assets before stockholders, although not before banks. On average, holders of defaulting corporate bonds recover about 72 cents on the dollar. Future defaults, however, will do worse, because recent changes to bankruptcy law have added to banks’ advantage.
Municipal bond defaults repay an average of 85 cents on the dollar for those with some sort of insurance and 70 cents for those without (the range of repayment goes all the way from zero to full face value).
That sounds grim, but remember that a 30 percent decline in a stock’s price has the same cost to the investor, and that happens even with healthy companies.
Since we are just entering the default phase of the bond market, this is no time to reach for yield. Review your holdings now and dump all issues rated B- and
You may already be looking at a loss on your below-investment-grade-holdings, but much worse lies on the horizon. The same can be said about junk-bond mutual and closed-end funds. They are already weak (Bloomberg’s index of high-yield mutual funds has a return of -8 percent this year), and they are likely to get weaker.
At this point in time, let’s check into our investments now, and make the necessary moves before it’s too late.
(Dick Halverson lives in