Tough Times Ahead for Junk Bond Issuers

A squeeze on junk bonds is likely to put some companies out of business in coming years. Odds are they won’t be able to refinance maturing speculative grade debt.

Right now, it’s not a particular worry. Call this the calm before the storm. Investors are buying issues of junk bonds, and the share of companies defaulting on their debt payments will be only around 4% by the end of this year. That’s well below the recent peak of 14%. Today’s low interest rates and moderate economic growth are promoting stability in the credit markets.

It helps, too, that total junk bond debt maturing this year is a manageable amount -- around $50 billion. But the amount will rise sharply in coming years, to $400 billion in 2014 alone. In contrast, total investment grade debt maturing will peak at roughly $200 billion in 2013 -- and decline to about $150 billion in 2014.

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About 71% of debt maturing in 2014 was sold in leveraged buyouts in 2007. That was before panic swept through the financial markets and before the recession began. Bank lending was strong, and a secondary market for securitized debt was thriving. The situation today is nearly the polar opposite: Banks are reluctant to lend, demanding much tougher terms. They’re building up capital. And the market for securitized debt is stagnant.

With economic growth likely to remain modest, many of the companies that borrowed in the easy credit days won’t have enough cash to refinance. John Bilardello, head of global corporate ratings at Standard & Poor’s, says: “The message for investors is don’t be complacent. Be aware.” The greatest risks, adds Bilardello, reside in five sectors: media and entertainment (including hotels and casinos), telecommunications, health care, technology and consumer oriented firms, such as retailers and restaurants.

The cost of borrowing for low rated firms is already on the rise as investors sense the potential for trouble ahead. The spread between junk bonds and safe 10-year Treasuries is widening. It surged to seven percentage points in early July, up from a two-year low of 5.5 percentage points just a few months earlier, in April, when most economists and investors expected that the economy would be growing more vigorously by now.

What’s more, year after year of large federal budget deficits will add to the pressure on companies seeking to refinance. As Uncle Sam competes for investment dollars, interest rates will climb.