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Tuesday, February 27, 2007


junk bond issuance

another point of view on the possibility of recession related by mark hulbert at marketwatch.

The year 2006 saw a record number of junk bonds come to market.

You might think this is good news, especially if you're an investor in junk bonds, which are euphemistically known as "high-yield bonds." But some advisers disagree, arguing that its significance is actually quite bearish.

Consider the arguments currently being made by George Putnam, editor of The Turnaround Letter, a newsletter that focuses on companies that are about to, are in, or which soon will be emerging from, bankruptcy. The service has a good long-term record, according to the Hulbert Financial Digest, ranking in second place for performance over the past 15 years among all monitored newsletters with an annualized gain of 16.5%, vs. 10.9% for the Dow Jones Wilshire 5000 index.

In the most recent issue of his newsletter, Putnam notes that, based on his review of junk bond issuance and bankruptcy filings over the last 20 years, "waves of high yield (junk) bond issuance (are usually) followed by new bankruptcies ... It appears that typically a four-year boom in high yield issuance is followed by a three-year spike in bankruptcies."

If so, recent trends are very bad news indeed, because not only did last year experience a record level of junk bond issuance, it was the fourth year in a row of heavy junk bond issuance. This suggests, according to Putnam, that "more bankruptcies may be heading our way soon."

To be sure, the supply of junk bonds coming to market is not a pinpoint short-term market-timing indicator. Indeed, two years ago, half way through the current four-year wave of heavy junk bond issuance, Putnam issued a warning similar to his current one, arguing that the large number of junk bonds coming to market "strongly suggests that we will begin to see a pickup in bankruptcy activity over the next few years." And, at least so far, this for the most part has not come to pass.

But that doesn't justify ignoring Putnam's argument altogether. Even though junk bond issuance may fail as a short-term market timing indicator, it's still possible that it is quite good at forecasting longer-term trends.

In fact, the evidence suggests that its long-term record might be very good indeed. Consider researched conducted by Owen Lamont, a professor of finance at Yale's School of Management. He has developed a comprehensive theory of the market's cycle based on companies' desire to issue stock, as measured by the percentage of the entire stock market that was newly issued over the preceding three years. This indicator reached its all-time high in 1929, and only slightly behind was the reading in early 2000. In third place was the reading in the early 1970s, just prior to the devastating 1973-74 bear market.

Few market timing indicators have as good a long-term record as that.

Lamont focused his research on the equity market, not on junk bonds, so care should be exercised when applying his conclusions to the current high-yield bond market. But his research provides a powerful foundation to the historical argument that Putnam is making.

What course of action should you take if you agree with Putnam that a bankruptcy wave is imminent? He suggests two: "Lighten up on high-yield exposure, and be ready for some opportunities in distressed bonds."

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