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.
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.