Default rates on junk bonds dropped 80% from their global peak at 10.9% in 2002 and ended the year at 2.2% as opposed to 5.2% at the start of 2004. The investors’ appetite for high-yield debt instruments compressed the interest-rate spread over “normal” bonds and gave a boost to the bond prices. The highly risky CCC bonds grabbed a 17.8% share of the market last year, an extremely dangerous proportion when assessed against 8.7% in 2003 and 2.8% in 2004.

"This is not a normal proportion of the market," says Hunkar Ozyasar, high-yield strategist at Deutsche Bank in New York. "At the moment, companies are in good shape with strong cash positions, but the longer this strong supply continues, the greater the chance something will go wrong."

Junk bonds are those rated Ba1 or lower by Moody’s or BB+ or lower by Standard & Poor’s and Fitch. These instruments usually carry a nice spread over investment-grade bonds to compensate investors for their higher risk.

The high-risk fixed income market that usually offers a healthy risk premium over the investment-grade bonds has seen shrinking yields this year as rising confidence about the economy, low rates and recovering balance sheets have lures investors of all stripes into the junk-bond market.

Junk bonds were first set in a separate category in the $4.6 trillion corporate-bond market in the 1980s. This year investors have seen impressive price gains in the market in combination with shrinking yields. In 2004 the return on junk bonds was 10.5%, according to the Bear Stearns High Yield index, and the average yield was at its lowest since the benchmark was created in 1985, 6.9%.
"There’s an extraordinarily high level of risk tolerance in the high-yield bond market," says John Lonski, chief economist at Moody’s Investors Service. "We’ve been saying for some time that the end [of the rally] is near."
Junk bonds have always been attractive as the returns matched those on stocks while the income remains fairly predictable. Optimists argue that the massive defaults of junk-bond issuers are not yet in sight. On the contrary, the annual default rate for issuers of high-risk debt has dropped to 2.6% in November as opposed to the average of 4% over the latest four quarters, according to Standard & Poor’s.
The riskiness of these investments as compared to the level of 1997 or early 1998 has increased. At the end of the third quarter, about 37% of junk bonds outstanding were rated B3 or lower as opposed to 31% in 1997.
"It’s not a good time to get involved" in junk-bond investments, says Michael Taylor, high-yield strategist at Bear Stearns. "There’s not much upside left."
Moody’s forecasts the default rate to drop to 1.8% over the first half of 2005, but rise to 2.7% by the end of the year.
"The improvement in aggregate credit seems to be slowing somewhat," said David Hamilton, director of corporate default research at the agency. "The default rate is at levels not seen since the high growth period of the mid-90s, so further declines are limited."