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

There have been ugly scenes in the junk bond market. It could turn into a full-blown panic – and that would be very bad news for stocks, says John Stepek.

150728-junk-bonds

The ugly scenes in junk bonds could spread to stocks

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

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

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.

Recommended

The charts that matter: bond yields turn back up and a new bitcoin record
Global Economy

The charts that matter: bond yields turn back up and a new bitcoin record

Bitcoin hit a new all-time high, while government bond yields turned back up. Here’s how that has affected the charts that matter most to the global e…
23 Oct 2021
Green finance is set to be the most powerful financial repression tool yet
Bonds

Green finance is set to be the most powerful financial repression tool yet

The government has launched its “green savings bond” that offers investors just 0.65%. But that pitiful return is in many ways the point of “green” fi…
22 Oct 2021
The charts that matter: bond yields slip while bitcoin tops $60,000
Economy

The charts that matter: bond yields slip while bitcoin tops $60,000

Cryptocurrency bitcoin soared to over $60,000 this week, while government bond yields fell back. Here’s how that has affected the charts that matter m…
16 Oct 2021
The charts that matter: Brent, bitcoin and bond yields flying high
Global Economy

The charts that matter: Brent, bitcoin and bond yields flying high

Government bond yields continued to climb, along with bitcoin and the oil price. Here’s how that has affected the charts that matter most to the globa…
9 Oct 2021

Most Popular

Properties for sale for around £1m
Houses for sale

Properties for sale for around £1m

From a stone-built farmhouse in the Snowdonia National Park, to a Victorian terraced house close to London’s Regent’s Canal, eight of the best propert…
15 Oct 2021
How to invest as we move to a hydrogen economy
Energy

How to invest as we move to a hydrogen economy

The government has started to roll out its plans for switching us over from fossil fuels to hydrogen and renewable energy. Should investors buy in? St…
8 Oct 2021
Emerging markets: the Brics never lived up to their promise – but is now the time to buy?
Emerging markets

Emerging markets: the Brics never lived up to their promise – but is now the time to buy?

Twenty years ago hopes were high for Brazil, Russia, India and China – the “Brics” emerging-market economies. But only China has beaten expectations. …
18 Oct 2021