The recent turmoil in the credit markets has created problems for issues of the highest quality debt all the way down to the junkiest of junk bonds which trade at ratings under "BBB" or "Baa."  When you have quality firms such as GE and Goldman Sachs paying nearly 10% for Warren Buffett to put on the corporate sweatshirt, and IBM forked out 8% for 30-year maturity debt. 

Imagine the rate which companies of lower credit have to issue debtat to attract investors today.  Now throw in outflows from fundmanagers who manage junk bond funds only adding to the lack of liquidity.AMG recently noted more than $470 million flowed out of junk bond fundsa week ago and said some $590 million was the latest week’s outflowsfrom junk bond funds.  That is the equivalent of losing the assets ofseveral entire closed-end bond fund per week.

A week ago we saw a report from Moody’s showing that the junkdefault rate would rise sharply to 4.2% by the end of 2008.  It alsosaid default rates could jump to a sharp 7.9% one year out.  Moody’ssaid that September’s default rate of 2.8% was the highest in fouryears and double the rate of a year ago. Now S&P has put junkdefault rates at even higher levels.  By September 2009 it seesdefaults reaching 7.6% and under its pessimistic scenario it noteddefault rates running possibly as high as 9.6%.

Reliant recently paid 14% for its capital depending upon yourcalculation.  To make matters worse, many junk rated companies have tostart issuing debt again next year.  If the credit markets stay verysoft along with highly volatile markets and a weakening economy withrecession numbers just hitting the tape, then many junk bond holdersare going to find themselves asking how much more risk they are willingto take on.  Wait until defaults actually do start to post seriousgains and see how investors will treat the junk bond field.

Some of the closed-end funds and ETN’s below will spell out some ofthe carnage we are seeing as a result of recent volatility and creditmarket malaise:

The PIMCO High Income Fund (NYSE: PHK) closed down almost 3% Fridayat $7.04.  This is down 50% from its 52-week high of $14.10, and theyield is now over the whopping 20% mark.   

The Western Asset High Income Fund II Inc. (NYSE: HIX) closed upover 2% at $5.88 today and it too has nearly lost half of the valuefrom its 52-week highs.  Its yield is roughly 18% at the currentdividend rates.

The BlackRock Corporate High Yield Fund V, Inc. (NYSE: HYV) closedup 4% Friday at $6.94 and it has also lost close to half its value overthe last year and now yields roughly 18% at current payout rates.

For an ETN, the iShares iBoxx $ High Yield Corporate Bd (AMEX: HYG)has lost more than 30% of its value from highs of the last year and itsdividend at current rates is north of 10% if those payouts are steady.

For another ETN, the SPDR Lehman High Yield Bond (NYSE: JNK) haslost close to one-third of its value and after a near-6% drop Thursdayand another 1% Friday its yield is over 12% at current payout rates.

At some point these will become almost too cheap to ignore. Junkbonds are at spreads and levels that have never been seen in most ofour careers. But the other issue is that investors have been fleeingthe sector relentlessly and we are formally just entering the recessionnow.  Wait until investors actually start reading about all the junkquality bond defaults reaching levels that haven’t been seen since the1980’s since before a zany man named Michael Milken entered the stage.

Closed-end bond funds used to trade at high premiums to their net asset values, but now most trade at substantial discounts. Tight credit markets have always unlocked before. Bad times do always pass.  In the end, there will have been one great opportunity to buy these funds at a major discount.  Whether that time is now or in 2009 is still an unfinished chapter. 

Jon C. Ogg
October 18, 2008

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