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BOHICA, pt. 4: Are Junk Bond Yields Signalling another Meltdown?

COMMENT: There is a mil­i­tary slang acronym “BOHICA,” stand­ing for “Bend Over, Here It Comes Again.” A recent arti­cle dis­cuss­es junk bonds yields being at a record low. This may be omi­nous, indi­cat­ing a sys­temic risk to the U.S. and glob­al economies.

The low yield is part­ly a result of ultra-low cen­tral bank rates, in addi­tion to a reflec­tion of a grow­ing mas­sive appetite for “risk” in the pur­suit of high­er inter­est rates.  Investors are make big, lever­aged, bets on low rat­ed cor­po­rate “junk” bonds that pay high­er inter­est than the ultra-low rates on safer secu­ri­ties (like trea­suries).  This means bor­row­ing costs for busi­ness­es have no where to go but up, an omi­nous state of affairs.

Note that the “spread” between the rates paid by junk bonds and the rates paid on trea­suries is still not at the record lows seen in 2007, so there isn’t quite as much gam­bling as pre­vi­ous seen.  The actu­al inter­est rates paid on the junk bonds, though, are at record lows because the cen­tral bank rates are much low­er now than before the melt­down.  So we might see the junk bond rates go a bit low­er as the “spread” nar­rows, but not much low­er unless the spreads between junk bonds and trea­suries plum­met to record ter­ri­to­ry again.

Over­all, this is rem­i­nis­cent to how the hous­ing mar­ket played out, where rates bot­tomed out, with a con­cur­rent huge amount of “risk tak­ing” in the sub­prime mort­gage mar­ket as rates dropped, and once rates start­ed ris­ing the hous­ing mar­ket start­ed col­laps­ing.  The record low junk bond rates also point towards ris­ing busi­ness bor­row­ing costs as being one of the poten­tial cat­a­lysts for a next finan­cial cri­sis, as ris­ing busi­ness bor­row­ing rates start knock­ing off the weak­est busi­ness that are hang­ing on by cred­it alone.  This would also be syn­chro­nized with a rise in mort­gage inter­est rates that slams the hous­ing mar­ket again.  So if you start see­ing arti­cles talk­ing about a trend­ing rise in junk bond yields, expect sto­ries of busi­ness bank­rupt­cies to fol­low.

“ ‘Junk’ Bond Yields at Record Low” by Aline Van Duyn and Nicole Bul­lock; Finan­cial Times;  2/18/2001.

Inter­est rates on “junk” bonds, or high-yield­ing debt, have hit an all-time low of 6.8 per cent, fuelled by investor appetite for riski­er assets amid grow­ing evi­dence that a US recov­ery is under way.

The demand for junk bonds, which are sold by com­pa­nies with rat­ings below invest­ment grade, has been robust this year, even as investors have pulled mon­ey out of oth­er riski­er areas such as emerg­ing mar­ket debt.

Yields on US high-yield bonds are now below their pre­vi­ous record of 6.81 per cent reached in Decem­ber of 2004, accord­ing to the wide­ly tracked index of the sec­tor com­piled by BofA Mer­rill Lynch. The index is cal­cu­lat­ed every evening, and reg­is­tered at 6.8 per cent late on Thurs­day.

“There are wide­spread indi­ca­tors that eco­nom­ic con­di­tions con­tin­ue to improve, and this is dri­ving yields low­er,” said Mar­tin Frid­son, glob­al cred­it strate­gist at BNP Paribas Asset Man­age­ment. “The cor­po­rate default rate, for exam­ple, will almost cer­tain­ly decline this year.”

The con­tin­ued pol­i­cy of near-zero offi­cial US inter­est rates has dri­ven yields down across finan­cial mar­kets.

As a result, investors have tak­en on more risk in order to boost returns and junk bonds have been a key ben­e­fi­cia­ry of that trend.

Investors poured $32bn into mutu­al funds that buy junk bonds in 2009, anoth­er $14bn last year and more than $5bn in the year to date, accord­ing to Lip­per, the fund track­er.

The strong demand for this debt has meant that even the riski­est of com­pa­nies have been able to bor­row mon­ey in the cap­i­tal mar­kets at his­toric low rates of inter­est.

The abil­i­ty to refi­nance matur­ing debts has sharply reduced default rates, with the glob­al rate falling to 2.8 per cent in Jan­u­ary from 12.6 per cent a year ago. Jan­u­ary also saw no new defaults, the first such month since June of 2007.

The drop in yields means that investors have a small­er cush­ion against ris­ing rates or an eco­nom­ic shock. How­ev­er, bond mar­ket experts point out that the risk pre­mi­um, or spread, to bench­mark Trea­suries, remains well above the lows reached at the height of the cred­it boom before the finan­cial cri­sis. The index shows a spread of 456 basis points to Trea­suries ver­sus 241bps reached in June 2007.

Mark Dur­biano, senior port­fo­lio man­ag­er at Fed­er­at­ed Investors, said the sec­tor remained attrac­tive, and would con­tin­ue to be so even if spreads stopped nar­row­ing. He said the inter­est paid was still high­er than that offered in many oth­er asset class­es.

“The time to start think­ing about shift­ing out of high yield . . . is when you think spreads are start­ing to move high­er, which typ­i­cal­ly hap­pens as the econ­o­my starts to weak­en or head toward a reces­sion,” Mr Dur­biano wrote in a note to clients. “Such a sce­nario is not on our radar at this time.”

The junk bond mar­ket plunged in val­ue in 2008. How­ev­er, in 2009, junk bonds notched up 57.5 per cent and last year the return was 15.2 per cent.


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