2008 December 04 Thursday
Market Projects 21% Junk Bond Default Rate

Speculative grade bonds might default at a higher rate than in 1933. Of course the market could be wrong. After all, it was wrong to buy so many of these bonds in the first place.

Dec. 3 (Bloomberg) -- Yields on speculative-grade bonds imply a U.S. default rate of 21 percent, higher than the record set during the Great Depression in 1933, according to John Lonski, chief economist at Moody’s Investors Service.

The extra yield investors demand to own U.S. high-yield bonds was 19.19 percentage points on Dec. 1, according to Moody’s. Assuming a 20 percent recovery rate, the spread implies a default rate of 20.9 percent, Lonski said yesterday in a market commentary. That compares with a rate of 11 percent in January 2001, 12.1 percent in June 1991 and 15.4 percent in 1933.

There's the default rate on junk bonds. But there's also the percentage of all bonds that junk bonds represent. Anyone have an idea where we stand on that score?

Deutsche Bank says the interest rate spreads predict a 50% default rate for junk bonds.

According to Deutsche Bank, current spreads imply a 50 per cent default rate for high-yield credits and an "inconceivable" default rate for investment-grade companies: government intervention to prevent defaults on such a scale, they believe, would be inevitable.

The high interest rates charged to higher quality companies are most interesting. Do these higher rates accurately forecast future default rates?

FedEx CEO Fred Smith sees the worst Christmas in at least 35 years.

It is by far the worst I've seen in the 35 years I've been in business. It's just gone right off the cliff. For retailers, I don't think there's going to be any Christmas to speak of. Some of our high-end retailers reported sales down 25%.

That big sales drop means lots of manufacturers and retailers will go bankrupt in 2009. How many? BorgWarner CEO Timothy Manganello is planning for a long recession.

We're preparing for nothing good until mid-2010. If things get uglier, it's possible it won't improve by then.

Junk bond yields are at record levels.

Junk-bond yields are at unprecedented high levels. As rattled investors dump everything but U.S. Treasury bonds, the average yield on below-investment-grade debt is over 20% for the first time ever.

So far massive US government intervention in financial markets hasn't stopped the contraction. Will the US government just keep upping the ante? By that point will inflation break out in a big way?

Some people are still deluded that we can put the Humpty Dumpty back together again. Harvard economist Edward Glaeser says that lending subsidies can't restore housing prices back to their distorted highs.

THE GREAT housing cycle of the aughts - the 73 percent increase in housing prices between 2001 and 2006 and the 22 percent decline since then - was built on three illusions. Too many homebuyers thought housing prices would go up forever. Too many investors thought they could lend without risk to subprime borrowers. Too many policy makers thought the magic of subsidized credit could permanently achieve a vote-winning trifecta of bigger homes, rising prices, and more homeownership.

The cruel reality of the market has shattered the first two illusions, but somehow the misconception persists that more lending subsidies can take us back to the housing markets of 2006.

Share |      By Randall Parker at 2008 December 04 11:01 PM  Economics Housing


Comments
Jerry Martinson said at December 5, 2008 12:26 AM:

I can understand gov't intervention to prevent bank failures as the $100k FDIC limit is a joke for large businesses that need to use banks. I also can understand some bailout to prevent substantial buck breaking in the money market accounts since these are essentially the modern equivalent of banks.

But I think the intervention should end there. Otherwise we are just going to distort the market and bail out even more idiots who took foolish risks. Nobody seems to be screaming about how it is unfair to those who foresaw the idiocy and invested wisely. Companies that bet wrong should have all shareholder equity destroyed. If you want to have Keynsian stimulus to fight the recession, it should be done in a way that doesn't reward poor choices.

averros said at December 5, 2008 3:39 AM:

Intervention always makes things worse. This has been known (and proven, from the first principles) for a hundred years now.

So why the surprise at failure of the millionth repetition of the same insanity? It's not remarkable in any way.

Wolf-Dog said at December 5, 2008 6:41 AM:

Right now the situation is so bad that unless the helpless majority (who are victims of the circumstances without any decision making capability for themselves) are helped by charitable government handouts, millions of Americans will starve in the streets, as their net worth will decline below zero when unemployment rises over 10 % next year.

James Bowery said at December 5, 2008 9:26 AM:

An $800 monthly dividend per adult citizen is not charity. What is charity is upholding "property rights", beyond homestead rights, without taxing them.

Tim said at December 5, 2008 11:39 PM:

This post made think about investing in Junk bonds, so I went to vanguard and looked at Vanguard High-Yield Corporate Fund (VWEHX). I laughed out loud when I noticed that it is compared to Lehman US Corp High Yield Index. I still may gamble a little on it though...

Jerry Martinson said at December 6, 2008 12:33 AM:

James,

I'm not sure if I'm understanding your comments.

While not straightforwardly so, isn't property (both real estate and other assets) already taxed in most areas? Most real estate has property tax. For example, I'm paying at a rate of about $80k/acre per year in a state that has the dreaded "prop 13". That sure seems like more than enough to cover the legal costs of protecting my ownership. On top of that there's annual title taxes and transfer taxes if I'm ever to sell the land. And you usually need private title insurance anyway so it's not like the protection is 100% gratis. Often there are legal easements and restrictions placed on your land that are essentially additional taxes (like denial of building permits, denial of sewer extensions to force a sale, "native tree preservation" laws in native prairies) that while theoretically legit often actually serve to fill local politicians coffer's with bribes (ahem... I mean donations and "consultant" fees).

Most other property is some sort of investment. If I sell land or any other investment I'll pay long term cap gains. Cap gains sounds like a fair way to soak the fat cats until you consider that most cap gains is mostly not real gains but "fake gains" due to inflation - why should I pay tax on inflation if it is not yet another property tax? Investment income is taxed, dividends are usually taxed twice (first corporate, then personal). My car re-registration is to be taxed on a formula relating to value. Corporations (even small mom-and-pop S corps) have to pay a minimum of $800 per year whether they make money or not in addition to local franchise taxes and have IRS-mandated asset depreciation curves that for high-tech equipment favor the tax man rather than match the true asset value.

Perhaps some forms of intellectual property aren't taxed yet require excessive legal costs.


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