Beware a credit bubble in junk bonds

With yields on junk bonds at record lows, it won't take much to wreck the party.

While equities have clambered back to record highs, the credit markets have been on fire too. Take junk, or high-yield bonds. As prices for these riskier bonds have soared, yields have fallen to record lows.

The Bank of America Merrill Lynch Global High Yield Index shows that yields fell below 6% this spring, an all-time low, and are currently around 6.4%. The record high of December 2008 was 23.2%.

Volumes "have gone through the roof", says Arnaud Tresca of BNP Paribas. Last year global high-yield issuance jumped 38% to $397bn. This year bond issues are likely to trump that figure. Companies are keen to raise cheap money from investors or refinance their debts.

Chalk the boom up to cheap money, says Ben Marlow in The Sunday Times. Record-low interest rates and money printing have left the financial system with lots of easy money but "a dearth of places to find good returns". So investors desperate for yield are snapping up risky firms.

The upshot is a return to irrational exuberance: investors are accepting the risk of junk bonds but the interest rates typical of government bonds before 2007.

Default rates are currently low, because yield-hungry investors are keeping dodgy firms alive by snapping up their debt. The Fed's decision to delay tapering has cheered the markets and kept the party going.

But with yields so historically low, there seems scant scope for further gains and any rise in interest rates could send default rates up fast, bursting this "epic credit bubble", says Joseph Baratta of Blackstone. Investors beware.

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