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Another Reason to Worry About Junk Bonds

The polite term might be “high-yield corporate debt,” but they aren’t called junk bonds for nothing.

Debt issued by companies with weaker balance sheets and less-than-stellar credit ratings (or what’s called “below investment grade”) is naturally going to be more likely to default, leaving investors holding just pennies on their dollars of principal — if anything at all.

Now, a return to the less-than-savory practice of hitting high-yield bond holders with what’s essentially a bait-and-switch is only pouring more junk into the junk-bond trunk.

The payment-in-kind option, known as a PIK-toggle, is making a comeback in the junk bond market. The PIK-toggle is a sort of circuit breaker for companies that find themselves struggling to make interest payments. It allows the borrowing issuer to switch from making payments in cash to making payments in kind — that “kind” being more of its own junk-rated debt.

The PIK-toggle was an increasingly common feature of junk bond issues in the years before the financial crisis, and now it’s slowly come crawling back.

Four private-equity-owned companies have issued high-yield debt with PIK-toggles in the last month, according to The Financial Times, citing data from S&P Capital IQ LCD: Jo-Ann Stores, Petco, Emergency Medical Services and Pharmaceutical Product Development.

In the case of Jo-Ann Stores, the new junk bond yields 10% as long it trades at par value. But if the company suddenly finds itself struggling and needs to direct cash to other uses, it has a PIK-toggle out, so rather than making those fat interest payments, it will just give bondholders more debt, FT.com notes.

What’s especially alarming is that although payment-in-kind is intended to give companies more breathing room if cash becomes scarce, studies show these issuers actually have significantly higher rates of default, says FT.com.

It’s a sober reality check for anyone riding the remarkable junk-bond rally of 2012. With central bank policy around the world making yield almost impossible to come buy, income-hungry investors are feasting on junk bonds.

The Barclays U.S. Corporate High Yield index is up 12.9% for the year-to-date through Oct. 12. Those are equity-like returns. Consider that the S&P 500 was up 13.6% over the same span.

And junk certainly beats the hell out of the ultimate safety play in debtland, Treasury Inflation-Protected Securities (TIPS). Even with their often negative yields at auction, TIPS are up an amazing — but far less remunerative — 6.7% in 2012, according to Barclays U.S. TIPS index.

As we noted last month, junk bonds look like they still have room to run, if only because demand shows no signs of letting up.

The risk-on trade, confidence that slow economic growth won’t slip into full-on recession (which would cause companies to default on their debts) and help from European buyers who are contending with even lower yields on safe government debt than their U.S. counterparts (bonds that also don’t pay squat), means too many investors simply want or need the yield.

Retail investors who invest in the sector through funds and ETFs like the the iShares iBoxx $ High-Yield Corporate Bond ETF (NYSE:HYG) or SPDR Barclays Capital High-Yield Bond ETF (NYSE:JNK) needn’t much fear PIK-toggle issues, since they’re essentially buying an extremely broad portfolio of debt.

You shouldn’t be assembling your own portfolio of high-yield securities, anyway. But if you are — as with everything else in life — make sure you get payment in cash, never in kind.

As of this writing, Dan Burrows held no positions in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2012/10/another-reason-to-worry-about-junk-bonds/.

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