Junk bonds (or "high-yield" bonds) are so called because they are loans issued by companies with low credit ratings.
As such, these bonds are riskier than most other bonds. That's why they offer a higher yield they have to pay extra to entice investors to take the extra risk.
Of course, in our QE-benighted era, you don't need to pay investors very much extra at all, in order to entice them to take more risk. Anything that offers a real' (after-inflation) return of more than 0% will do the job.
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So it's been a positive bonanza for enterprises that might struggle to get funding in any other market environment.
But there were tentative signs last week that this might be changing...
What's rattling the junk bond market?
Last week, two junk-rated companies in the US scrapped plans to issue new debt (in other words, they wanted to borrow money, but couldn't be confident of generating sufficient interest at the right price).
On Thursday, NRG Energy, an electricity utility, abandoned its offering. And on Friday, coal producer Bowie Resources Partners followed suit.
Meanwhile, investors pulled money out of US-based junk bond funds for the second week in a row, notes Reuters. It was enough to have the more excitable news providers rolling out the word "rout" in their headlines last week.
So what's going on?
It's worth remembering that even though the biggest junk bond exchange-traded funds (ETFs) have seen their biggest drops in a few months, this is nothing particularly dramatic as yet (the biggest players are down roughly 2% for the quarter rubbish compared to equities, for example, but hardly a massive bear market).
Indeed, once upon a time, no one would have batted an eyelid at this sort of fall. It's just that everyone's grown so used to everything going up all the time, that any little scrape is enough to give us all a fit of the vapours.
It's also worth noting that for context, before this sell-off, the gap between the yield on US Treasuries (the safest debt in the world) and junk bonds (the "spread") had fallen near to its lowest level since the financial crisis. The last time it was this low was in mid-2014.
In other words, junk bonds might have fallen, but they've fallen from a very high level. Junk has returned more than 14% a year on average since 2009, compared to a 20-year average of 9.05%, so it's had an excellent run.
Also, as the Wall Street Journal points out, it's not as though the market has frozen over. "At least five companies with low credit ratings successfully sold bonds on Thursday and Friday."
Still every nasty fall starts from a high point, so while we shouldn't get too stressed about this, we shouldn't ignore it either.
A number of things could have rattled the market specifically last week. There have been a number of disappointments on the corporate earnings front. Results from companies in the telecoms and healthcare sectors in particular have caused the odd upset.
For example, commercial radio operator iHeartMedia tanked after weak results, while news from telecoms group CenturyLink also disappointed. The collapse of merger talks between Sprint and T-Mobile haven't helped sentiment on that front either.
Also, Donald Trump's tax plans look like having a sting in the tail. Firstly, they could be delayed until 2019. And secondly, they could contain a clause that makes it harder to recoup debt interest costs by offsetting them against your tax bill. Analysts estimate that this could impact on about 40% of the junk bond market.
If a company is unable to offset as much interest, then it will become less profitable, and in turn more risky (this is exactly what's happening to buy-to-let investors in the UK). That doesn't seem at all bullish for junk bonds.
Why investors would be wise to be wary of high yield right now
However, it's more than just a few bad pieces of news. Investment analysts generally have been growing more bearish on high-yield they feel that we're entering the "late cycle", which means they won't do as well.
Basically, bond markets tend to get bearish before equity markets. You can look at bond investors as being glass half-empty people, and equity investors as being glass half-full people. There's a logical reason for that, and it's not just because bond investors are cleverer than equity investors.
With equities, the upside is effectively unlimited and as a result, that's what everyone focuses on everyone hopes they'll land a multi-bagger. So the inclination is to look on the bright side and only pay attention to the downside when it's staring you in the face.
With a bond, you pretty much know what return you will get on the day that you buy it. Assuming that everything goes to plan, you know what your nominal return will be if you hold the bond until it matures. So there's a real incentive to focus on what can go wrong, rather than what might go right.
With high-yield prices so high and the contract conditions so loose (ie, lenders have few mechanisms for enforcing discipline on borrowers), there's a lot that can go wrong. And given the high and rising level of debt that corporations are currently carrying, notes credit rating agency Moody's, you'd expect defaults to start rising. That's not what investors are currently pricing in.
As Luke Hickmore of Standard Life Aberdeen told Bloomberg: "You're not getting paid an awful lot for default risk; as an investor you have to be very, very careful." It doesn't help that interest rates broadly are rising, albeit very slowly. If the rate on safer bonds goes up, then junk bond rates will have to do so too, to retain their appeal for investors.
What does it all mean? There's no need to panic right now. But it's worth keeping an eye out for signs of stress in the credit markets. If people are getting worried that companies won't be able to pay back their debts, then that's not great news for equities in the longer run either (after all, equity owners are even further back in the queue to get paid than junk bond investors).
Also, just watch out for more signs that companies and economic data are disappointing rather than pleasantly surprising investors. When asset prices are as high as they are now, it doesn't take a lot to spark a correction or something bigger.
