"Distressed debt, bonds that have plunged in price because of troubles at the issuer, have lost 19 percent this year, according to Merrill Lynch
, after posting gains of 25 percent in 2004.
The Federal Reserve has raised interest rates to 3 percent from 1.25 percent in June 2004 to keep inflation in check as oil and other costs rise. Rising rates usually hurt the shakiest companies because they are the first to lose access to financing when money supply gets tighter.
Downgrades of Ford Motor and General Motors to junk status this month also contributed to the poor performance of risky bonds, strategists said. Yields on some automakers' bonds have surged above 7 percent since the May 5 downgrades, making low-rated bonds from smaller companies less appealing by comparison.
But so many bonds have been sold by low-rated companies that there is potential for much more distress in the market than at other times, she said.
The global junk bond default rate declined to 2 percent last month from a peak of nearly 11 percent in January 2002, according to Moody's Investors Service. The rating agency expects defaults to start climbing from April's lows, however, because of the rise in bond sales from risky companies.
Distressed bonds returned a whopping 78 percent in 2003 and 25 percent in 2004, according to Merrill Lynch, but those gains likely signaled an overheated market by late last year, strategists said."
So, what does this mean for the market as a whole?
Investors may be taking profits. The 78% and 25% annual returns for '03 and '04 would lead many investors to pullout of the market. Simply put, no market goes up forever. And no one went bankrupt taking a profit. This is a good possibility.
However, pullbacks from the market could also be a signal that some investors are concerned about the underlying fundamentals of a particular market. No one wants to invest in a dog. And if investors are concerned about fundamentals, they will sell assets in a questionable sector. Lending credence to this argument is the higher-degree of sophistication of the average high-yield investor. The high-yield market can be extremely illiquid - meaning it can be extremely difficult to sell a particular bond. Only an investor who can actually live with a loss usually makes an investment in this type of asset. In addition, there is a higher probability that a high-yield investor will become a bankruptcy creditor. This can be a long and drawn out process with absolutely no guarantee of any claim. The illiquid market and higher possibility of ending up as a creditor means an investor will perform a great deal of sophisticated research to decide whether or not to invest in a company. These two activities are more in the purview of the sophisticated investor. As a result, these are people who are more likely to be "in the know", investors who make the early moves into and out of a particular asset class. This is also a good possibility as an explanation for the sell-off.
So, we probably have a combination of simple profit taking and sophisticated investors pulling out of the market. As a result, taking notice this event is warranted.