Junk bonds may really be junk - for investors

Posted Feb 6th 2008 11:16AM by Tom Taulli
Filed under: Deals, Private Equity

It seems strange to invest in a security that is called "junk." But it's a huge business that can be quite lucrative. Hey, it made Mike Milken a billionaire. What's more, junk bonds have become a key financing mechanism for growth companies as well as leveraged buyouts.

The market for junk bonds has been particularly strong over the past few years, with a large spread between junk and high-quality securities was. That is, until the "credit crunch" hit Wall Street in August.

Now, Edward Altman – a professor and a finance guru – is predicting some grim news for junk bonds for this year. Basically, he thinks the default rate will spike to 4.64%, according to a piece in the Wall Street Journal [subscription required]. Keep in mind that the default rate was a paltry 0.51% in 2007.

If Altman's prediction proves to be true, it will be particularly bad for private equity investors. In the event of a default, the equity holders can get wiped out. Thus, we could see a plunge in private equity returns.

What's more, the credit crunch will make it tough for companies to refinance their debt loads. Oh, and if the economy slips into a recession, then EBITDA levels will likely fall.

In fact, we are already seeing defaults, such as the bankruptcy filings at Allied Van Lines, Tousa and Plastech Engineered Products.

Unfortunately, Altman sees the negative trend lasting into 2009, with a default estimate of 5%.

Tom Taulli is the author of various books, including The Complete M&A Handbook and The Edgar Online Guide to Decoding Financial Statements. He also operates DealProfiles.com.

Tags: edward altman, EdwardAltman, inthenews, Junk Bonds, JunkBonds, Mike Milken, MikeMilken