Junk bonds: apocalypse postponed

Investors were selling in droves last year and in early 2016. But now they’re back with a vengeance. US high-yield, or junk, bonds, the riskiest segment of the corporate credit market, are among the best-performing major assets this year. They have produced a total return of more than 7%. Energy-sector junk bonds, which were in particular trouble due to the oil-price slump, have notched up 15%.

As prices have rebounded, US junk-bond yields have fallen back to 7%, below the 8.5% average of the past ten years. At the peak of the junk-bond boom of recent years, yields fell below 6%. In total return terms, the Bank of America Merrill Lynch high-yield index is almost back to its all-time highs seen last year.

“There’s a less apocalyptic view of the world” among investors now, as Aberdeen Asset Management’s Greg Hopper told Bloomberg.com. Late last year, investors were gripped by a deflation scare as oil tanked, China wobbled and US data also softened. Now, however, China’s fiscal and monetary stimuli have kicked in.

Meanwhile, “it also seems increasingly likely that the worst of the oil crash
is over”, says the FT’s Robin Wigglesworth. And the US Federal Reserve was spooked enough by all the volatility “to hit the pause button on further interest-rate rises” after its December hike. “That means a Goldilocks scenario for junk bonds, with the economy strong enough to keep corporate suffering contained but not strong enough to warrant more aggressive US monetary policy.”

Nonetheless, the fundamentals really don’t appear to have improved enough to warrant such a strong bounce. American earnings have turned down recently, and revenues are also falling, says Wigglesworth. The US default rate, on a trailing 12-month basis, has hit a six-year high of 3.9%, and Standard & Poor’s reckons the figure could hit 5.5% by March 2017.

A key problem is that credit quality has deteriorated as the multi-year rally has progressed. Forty percent of the overall junk-bond market is now made up of the lowest-rated segment, triple-C bonds. And there is a lot more debt to deal with too: junk-rated American firms have debt equal to around 48% of their assets now, up 7.5% in seven years.

On top of this, almost $1trn of junk debt is set to mature in the next five years, and many firms will struggle to refinance if the economy slumps or interest rates rise, or both. Junk bonds, like other assets, were saved from a purge post-crisis by quantitative easing and near-zero interest rates. But as Bonnie Baha of DoubleLine points out, this means the Fed merely “deferred the credit cycle” – implying a worse bust later.