Holiday Review

Memorial Day is now behind us. Before we sink into the so-called summer doldrums (I haven't had a slow summer since 1999), let's recap market news.

Money has been flowing into high yield bond funds at a brisk pace as investors believe the worst is over. The reach for yield has begun. However, it may have begun prematurely.

High yield bond (bonds rated below investment grade) defaults have been very modest. In fact, not only are they unusually low for a recession, they are in the range the approximate pace for typical economies of about 5%. This was discussed on Kudlow & Co. last week. This has some strategists questioning earlier forecasts of 10% or higher corporate defaults. Will defaults be milder than during past recessions? Maybe, maybe not. As they say: "Timing is everything".

During the economic boom of 2003 - 2006, corporate borrowing costs were at or near all-time lows as investors reached for yield and were willing to accept lower and lower rates of return for high yield risk. Investors went well beyond their stated risk tolerances to pick up every last basis point of yield.

This was a boon to companies with lower credit ratings as it drastically reduced borrowing costs. However as Guns and Roses sang: "Nothing lasts forever, but a cold November rain." Most high yield bonds have maturities between five and ten years. The result is that many bonds issued during the economic boom may not have to be replaced with new debt for another year, two or three.

This could be a problem for some lower-rated companies as treasury benchmarks are expected to rise. As it is unlikely that credit spreads revisit historically-tight levels last seen mid-decade, replacing current debt may be cost-prohibitive for some issuers. The real story may not be that corporate bond defaults are milder this time around, but that the so-called great moderation earlier this decade left corporate borrowers with relatively under stressed balance sheets for the time being, but judgement day is approaching. Corporate days of reckoning may be delayed, but they have not been eliminated. Companies that could afford to pay their debt at rates in the 6.00% to 8.00% area may not be able to afford borrowing costs which could be in the 10% to 12% area.

Speaking of junk bonds. The GM bond for equity exchange went over like a lead balloon. Some of my sources stated that not even 10% of outstanding bondholders signed up for a ride down GM's capital structure. Bankruptcy appears almost inevitable at this point. June 1st will be judgement day for GM as the company has stated that it cannot pay its convertible bond coming due on that date. The tough love of a true bankruptcy (as opposed to the pre-packaged sham foisted upon Chrysler creditors) may be just what GM needs to become long-term viable. Look for the Obama administration to try some last minute legal trickery to avoid a true restructuring (which would be detrimental for the UAW).