Take your meager winnings and run before default rates for low-grade bond issuers spike next year. By Andrew Tanzer, Senior Associate Editor December 18, 2007 The high-yield bond market has been out of the spotlight recently. Junk bonds have been upstaged by more toxic and esoteric fare such as collateralized debt obligations (CDOs) anchored to subprime loans. But junk bonds could move toward center stage again next year. Default rates for low-grade bond issuers will be appalling if the economy falls into recession, cautions Martin Fridson of FridsonVision, a high-yield bond research firm. First, some context. Fridson, who publishes Leverage World and Distressed Debt Investor, says that junk bond values reached a historic peak (measured by the narrowness of the spread between junk yields and Treasury bond yields) in June 2007, when they bottomed out at 268 basis points over Treasuries (a basis point is a hundredth of a percent). In the past six months, spreads have doubled, to 550 basis points. The default rate for high-yield bonds has also been at a record low, 1%. Advertisement Moody's projects that the default rate will soar to 4.2% over the next year. That's slightly lower than the average default rate of junk bonds over the past decade. Fridson arrives at roughly the same forecast using an assumption of no recession. For example, his historical analysis of the market shows that 22% of distressed issues (defined as bonds not in default that yield at least 1,000 basis points, or ten percentage points, more than Treasuries) default within 12 months. The number of distressed bonds has soared over the past several months, from 80 in September to 159 now, many of them in the housing and building-materials industries. For instance, Beazer Homes and Standard Pacific, two big homebuilders, are now in the distressed camp. Georgia Gulf, a chemicals company that mainly serves the construction industry, also has entered the ranks of the distressed. But what about actual defaults, which are already on the rise? Fridson says that when economic growth slips below 2%, defaults start to spike. He explains that when cash flows weaken and corporate borrowers aren't meeting financial tests and loan covenants, banks are more likely to pull the plug. Advertisement Recall that Moody's and Fridson's forecast of defaults quadrupling to 4% in 2008 assumes no recession. What happens if, as many economists forecast, we do have a recession. That will be ugly indeed for the high-yield sector, says Fridson. "The vulnerability is very high because the quality of the mix of bonds is very low," he says. Fridson looks closely at two factors to project recession default rates. First, he analyzes the outstanding mix of ratings of speculative grade bonds (for example, bonds rated Ba or B or Caa by Moody's, with Ba representing the best quality in the junk-bond heap). He says the ratings have historically been a highly accurate statistical indicator of tendency to default in an economic downturn (C grade is likelier to default than B, and so on). Then he studies the actual default rates in each past recession, broken down by investment grade. Here's his conclusion. Given the current mix of high-yield bonds, which is of extremely poor quality by historical standards, the default rate will jump to 8.1% if we suffer a light recession, such as the one that struck in 2001. Advertisement If we have a deeper, longer recession such as the 1990-91 downturn, the default rate will explode to 16.3%. When was the last time the default rate for high-yield bonds spiked that high? In 1933, in the depths of the Depression, says Fridson. Despite taking big hits in June, July and November, junk bonds are still in the black in 2007. A Merrill Lynch high-yield index returned 2.9% year-to-date through December 11, and the average high-yield mutual fund returned 2.2%, according to Morningstar. So if you own a junk-bond fund and the economy really is about to enter a recession -- or is already in one -- this might not be a bad time to take your meager winnings and run.