Should you load up on American junk bonds?

Very few assets around the world are cheap these days, says Ben Inker of investment manager GMO, but US high-yield debt appears tempting – and is certainly no worse than fair value. Junk-bond spreads – the yield over risk-free US Treasuries – are around 8% today, “significantly wider” than average. However, while GMO has dabbled successfully in the market, it is “not yet leaping in… with both feet”.

That’s because it reckons a new default cycle is looming. As defaults rise, the market tends to “overshoot fair value”. The average annual default rate since 1988 has been 4.6%, says Inker, but it oscillates wildly. In “calm times” it is around 2%-2.5%, but it can rise as high as 15%.

Moreover, it’s not easy to predict – the nastiest economic downturn needn’t match the worst wave of defaults. In 2008-2009, for instance, the default cycle was not as bad as in the early 1990s and 1998-2003, because unprecedented stimulus kept troubled borrowers afloat.

Factor in historical recovery rates too, and the upshot is that at current yields junk is a bargain at 2% default rates and still good value even if default rates reach the long-term average – even a repeat of the 1998-2003 tech bust would imply a return of 1.6% above Treasuries. Only in a Great Depression scenario would you lose your shirt, says Inker.

Still, be careful. The junk-bond market is notoriously skittish and illiquid, and now that banks are no longer market makers owing to regulatory changes, it may be especially prone to sharp falls below fair value.

disfi.com