Junk bond distress levels surge, signalling defaults

More than 30 per cent of European high-risk, high-yield bonds are trading at distressed levels, the most in five years, stoking speculation defaults will rise.

Investors demand an extra yield over government debt of more than 10 percentage points to hold 53 of the 169 bonds in Merrill Lynch & Co’s Euro High Yield Constrained Index. That’s the biggest proportion of distressed debt since March 2003, in the aftermath of the September 11 terror attacks and the dot-com crisis.

“Typically, those levels of distress would indicate that defaults are going to rise,” said Karl Bergqwist, who manages the equivalent of about $500 million in high-yield debt at Gartmore Investment Management in London.

“We think there’s much worse to come. Spreads could go a lot wider and defaults are undoubtedly going to go up.”

Defaults on European speculative-grade corporate bonds will climb to 2.3 per cent in a year, from 0.7 per cent now, near a record low, Moody’s Investors Service said in a September 8 report. Worldwide defaults will surge to 7.4 per cent, from 2.7 per cent.

Spreads on high-yield debt have widened as investors, fleeing the fallout from the collapse of the US sub-prime- mortgage market, shun all but the safest bonds and as banks tighten lending standards. The average yield in the Merrill High Yield index, an indication of the absolute cost of debt to companies, is now 12.3 per cent, twice the level of last March.

Market Closed: Europe’s primary high-yield bond market has been effectively closed since July 2007, data compiled by Bloomberg show.

Last year, companies borrowed the equivalent of $32.1 billion using such securities, with all but $5 billion in the first half. Now, amid spiraling money-market rates, investors are wary of speculative borrowers. High-yield, or junk, bonds are those rated below Baa3 by Moody’s or BBB- by Standard & Poor’s.

“If companies find it difficult to raise money in the bond market at the same time as banks are tightening lending, then the probability of default increases,” said Guy Stear, a strategist at Societe Generale SA in Paris. “That’s the case even if the fundamental business is sound.”

The New York-based ratings firm expects makers of durable consumer goods such as furniture, floor coverings and fridges to show the highest default rate in Europe.

The companies with the largest share of bonds in euros at distressed levels are General Motors Corp and its finance unit, General Motors Acceptance Corp, according to Bloomberg data.