When people talk of junk bond rallies (and they have been talking – a lot) what junk are they referring to exactly?
The standard index for high-yield bonds, or US corporate bonds rated below investment grade, is the Bank of America Merrill Lynch High Yield Index. It is also an index that varies in its composition.
Courtesy of Jim Fickett over in the Long Room:
In most discussions of the high-yield bond market, historical spreads play a major role. But comparing spreads today to those of the past assumes that junk bonds are a constant entity over time. Unfortunately, junk is junkier today, as illustrated by this chart [at left] from last October’s Global Financial Stability Report.
The fraction of CCC or lower-rated bonds approximately doubled from early 2007 to early 2009. And according to a recent report from Fitch, the fraction at the end of 2009 was still 27%.
You can argue that the proportion of CCC-rated bonds is bound to rise as ratings agencies downgrade securities post the financial crisis. In that sense, perhaps, the “junkiness of junk,” as Fickett calls it, is finally being accurately represented within the index, in terms of ratings.
But the preponderance of CCC-rated material is still very much worth noting, given recent high-yield mania.
We wrote a couple of weeks ago that the spread between the BofAML High-Yield Index and 10-year US Treasuries, essentially the premium investors demand to hold the riskier assets, is nearing pre-crisis lows. It’s forecast by some analysts to dip below the median level for 2002-2010 by the end of this year. Risk is being repriced in a dramatic way; investors are lapping it up in the corporate space.
What’s more, if you drill down into the the index — splitting out BB-rated junk bonds from CCC-rated ones, investors’ recent love of high-yield debt becomes even clearer.
From Bloomberg:
Debt ranked in the BB category gained 39.1 percent in the past 12 months, underperforming the CCC tier by 66 percentage points, according to Bank of America Merrill Lynch index data.
Related links:
WSJ vs Bloomberg on credit investors’ risk appetites – FT Alphaville
Pricing risk redux – FT Alphaville
Junk bonds sell in record volumes – FT