Air escapes from the junk-bond bubble

published 1 August 2014

In the easy-money era of the past few years, one of the most eye-catching bull runs has taken place in the highest-risk part of the corporate bond market, known as junk bonds.

Corporate debt with high yields, reflecting a higher risk of default, has been so popular that yields have plummeted as prices have surged. According to Barclays, average junk-bond yields hit a record low of 4.8% in June.

In the pre-crisis era, that would have been the yield on a bond issued by a government with solid finances, as opposed to a risky company. Junk bonds are "extremely overvalued", says Martin Fridson of LLF Advisors.

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To make matters worse, covenant-light loans, which contain fewer protections for creditors, have proliferated: cov-lite' lending in the US is up 41% on last year. "When you see these deals being done at ever lower yields, it tends to be time to rotate out of high yield," says Jon Mawby of the GLG Flexible Bond.

US Federal Reserve chair Janet Yellen said, in mid-July, that junk was looking "stretched", which may explain why investors have stepped back recently: average yields rose above 5% last week.

But whether this proves the high watermark of the junk bubble or a pause, the frenzy of lending at record-low rates portends a big wave of defaults a few years down the track.