The Globe and Mail

  Junk Bonds Mean Money’s Too Tight to Mention


Friday, February 28, 2003

It’s time for everyone’s favourite game show, Junk Bond Challenge! The rules are simple: We describe a big US corporation that has a debt note with a current yield that would warm the cockles of a loan shark’s heart, and then you guess the name of the mystery company. (Answers appear at the end of this column -- no peeking!)

Number 1: This enterprise includes one of the most famous research labs in the world. Over the years it has produced 11 Nobel laureates and such cool toys as the laser beam, the transistor and the communications satellite. The boffins at this firm are still cranking out an average of four patents a day, but they haven’t yet figured out how to spin electrons into profit. Their 7.7 percent bond that matures in 2010 offers a current yield of 22 percent.

Number 2: Everyone knows airlines are about as popular as black flies to someone portaging a canoe, but do you want to walk to your condo in Costa Rica? Lots of folks want to keep flying, and this company operates more airplanes to more places than any other in the United States. Its 9 percent notes due in 2006 offer a high-altitude yield of 30.3 percent. Something special in the air, indeed.

Number 3: Even in a recession, people still have to eat, so shouldn’t the grocery sector be a defensive play? It seems not, given the recent meltdowns of Ahold and A&P. This beleaguered grocery wholesaler is dealing with a SEC probe and a concerted attack by short sellers, not to mention the bankruptcy of their largest client, Kmart. The 9.9 percent notes due in 2012 offer a mouth-watering yield of 31.9 percent.

We don’t own any of these high-yield bonds, preferring to place our bets on outfits with low debt or debt at reasonable interest rates, but savvy investors such as Warren Buffett and Martin Whitman of Third Avenue Funds do buy into situations like these.

For us, this exercise amplifies the precarious nature of many of America’s mainstream corporations. What does it mean when these bond yields contain such a rich risk premium? Remember: in most cases, if the bondholders do not get paid in full, the common shareholders ordinarily get next to nothing.

This is another piece of evidence that the United States teeters on the slippery slope toward a full-blown credit crunch. The US Federal Reserve’s policy of lower interest rates helps, but is looking more and more like an effort to push on a string.

Banks have frozen lending. Companies that desperately need money can’t get it, while those who would qualify have little incentive to borrow as demand is weak. And the supply side of the equation remains ample, as few enterprises, even those operating under bankruptcy protection, have actually gone out of business.

Optimists can talk about low inventory levels and presidential cycles until the cows come home. However, until companies get some help surviving today, in a way that does not hopelessly undercut tomorrow’s shareholders, it will be difficult to persuade the bear to go back to his cave.

Answers: 1) Lucent; 2) American Airlines (AMR); 3) Fleming Companies.