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Junk Bond Defaults Are Rising
Higher interest rates and tightening bank standards are raising concerns over certain bonds known as collateralized debt obligations. Last year Moody’s downgraded 27; this year (through the first quarter) Moody’s has downgraded 13 more and added 22 to the watch list.
Known as CDOs, these investments are unsecured loans and high-risk bonds that are pooled together in “tranches”. Tranches are segregated by risk and then sold to private investors. While the top tranche usually is rated double-A or higher, the bottom tiers (the equity and the mezzanine tranches) are the first to suffer losses in a default.
The deals are structured to weather default rates of up to 2.4%. Anytime defaults hit 4%, an investor’s equity in the riskiest tranches usually is wiped out. Moody’s estimates that junk bond default rates reached 5.6% last month, and forecasts that the default rate will rise to 7.7% by April, 2001.
Source: Investment News, June 5, 2000
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