Keep an eye on the rout in junk bonds – it could spread fast

Away from the spotlight of the Greek crisis and the Chinese stockmarket crash, there have been ugly scenes in a corner of the bond market.

High-yield – or ‘junk’ – bonds have been hit hard by the recent plunge in commodity prices.

In fact, the yields on the riskiest junk bonds are now higher (and prices are now lower) than when the oil price crash first panicked investors late last year.

Yet they could have a lot further to fall.

And it’ll be interesting to see how the market copes with the revelation that even low rates and quantitative easing can’t stop companies from going bust.

The problem with high-yield debt – there’s too much of it

The high-yield debt market has exploded in recent years, against a backdrop of low interest rates and investors hunting for yield. And that’s given rise to a capacity issue that investors don’t always consider.

Izabella Kaminska of FT Alphaville flagged up an interesting report on the sector by UBS’s Matthew Mish and Stephen Caprio this morning.

Before I carry on, you have to understand that the bond market is very different to the equity market. You probably already know that a bond is just an IOU – you loan a company some money, it promises you an interest payment and your money back after a set period.

A share, on the other hand, is ownership of a part of the company. It’s riskier – you are behind the bondholders in the queue if a company goes bust – but you also get to share in the company’s potential success in a way that bondholders don’t.

But this is far from being the only difference. By and large, one share is the same as another. You sometimes get preference shares, or different classes of share, but that’s relatively rare, and it’s not something most investors need to worry about.

So if you’re thinking about buying shares, you’ll usually do some analysis on the underlying company, but you don’t have to fret too much about the actual share issue itself.

Bonds are different. As well as different maturities (the date you get your money back) and different coupons (your annual interest payment), they come with different conditions attached too.

So not only do you have to understand the quality of the underlying company, you also have to understand the characteristics of the individual bond itself. And if you’ve ever seen a bond prospectus, you’ll realise that this is quite specialised and time consuming.

This gets us to Mish and Caprio’s point. “The overall HY [high yield] market has doubled in size; sectors that witnessed more buoyant issuance in recent years like energy or metals mining have seen debt outstanding triple or quadruple.”

So, in short, there are a lot more bonds out there. And there’s a bigger appetite for them too. Plenty of new investors – many of whom may have little experience in bonds – have been piling into the market. Exchange-traded funds (ETFs) have helped to improve access to the market, for example.

Thing is though, who’s actually sitting down and analysing these bonds? There’s the rub, say Mish and Caprio. “Simply put, the growth of the credit markets has not been matched by the addition of research resources (eg credit analysts).” The reality is that “some investors have not added the resources necessary to do the fundamental credit work for today’s bloated HY market”.

Why good analysis matters

Sure, you might argue that this is a couple of analysts making the case for a pay rise or a bigger team. And maybe it doesn’t sound like a big deal anyway.

Or at least it doesn’t until you remember that the basic problem with the subprime crisis was that investors, desperate for yield, dived into financial instruments that they didn’t really understand, on the assumption that someone else had done their homework for them.

It’ll be interesting to see how a full-blown panic – against a backdrop of minimal bond market liquidity – might play out. In fact, we might be seeing the start of one now.

Energy sector bonds – particularly those of coal companies, which are being crushed, and overstretched shale firms – are collapsing in value. But as Wolf Richter of the Wolf Street blog points out, with the Fed threatening to raise interest rates, the rout won’t stop at the energy sector.

High-grade bond investors know that “the fire starts at the riskiest margin and works inward. And they’re seeing, despite whatever denials they might have, that this process has begun, just when US corporations carry a far greater load of debt than ever before… while revenue growth is stalling.”

A more hostile bond market would also be bad news for the stockmarket. A lot of this debt has been issued to fund share buybacks, after all.

What can you do? We haven’t been keen on bonds in general for some time. As far as equities go, stick with markets that are near the start or middle of their quantitative easing cycle rather than ones that are closer to the end – that’s one reason why we favour Japan and Europe over the US.