Another day, another story about the ongoing boom in junk debt. This time from Bloomberg:
The extra yield investors demand to own high-risk debt rather than government bonds has dropped 82 basis points this month to 540 basis points, or 5.4 percentage points, the lowest since Nov. 16, 2007, according to Bank of America Merrill Lynch’s U.S. High-Yield Master II index.
Goldman Sachs Group Inc. and JPMorgan Chase & Co. are advising clients to buy speculative-grade debt in 2011, even after gains of 14 percent this year and a record 57.5 percent in 2009.
And if you thought the $300bn+ in issuance this year would go a long way towards satiating investor appetite, you’d be mistaken:
High-yield bonds will return about 7 percent to 12 percent in 2011 as defaults are “near zero” for the next few years, said O’Reilly of Neuberger, which in the past 13 years has owned one security that defaulted.
Guggenheim’s Minerd is adding junk bonds, focusing on those with B ratings in the 7- to 10-year range that yield more than 10 percent, and shorter-term notes that pay at least 6 percent.
Up to a point, this makes sense. There was a massive wave of distressed company defaults in 2009, and in 2010 the activity in high yield has essentially reflected the broader trends in the US economy and macroeconomic policy.
Balance sheets improved substantially as companies continued hoarding cash and deleveraged after their pre-crisis binge. Credit quality looks better as default rates have plummeted. And the lax monetary conditions made it easy for low-grade companies to refinance, which suited investors searching for a bit of extra yield just fine.
So perhaps another year or two of these conditions will bring juicy returns.
But — and you just knew there was a but — as we’ve said repeatedly there are good reasons to look skeptically upon all this activity. And to be honest, we don’t exactly how to interpret much of it.
As if anticipating our reaction, Moody’s has just released a report with an overview of the problems that can be gleaned if you look more than just a single year out. Start with this graph:
That’s the dreaded wall of debt maturities for companies rated B3 negative and below.
When we write that easy Fed-driven credit conditions have made it easier for companies to refinance, this is what we’re talking about. Here’s Moody’s:
This wall of debt maturities remains the concern. Many speculative-grade companies have taken advantage of an accommodating high-yield bond market to refinance near-term debts. While that has allowed many to avoid default and continue to ride out the halting economic recovery, it has built a towering debt obligation in the years ahead. Refinancing these maturities could be untenable if the high-yield market begins to close off to riskier credits.
The speculative-grade default rate at the moment stands at 3.5 per cent, and Moody’s expects a decline to 2.1 per cent next year. But look further out, and things get a lot more complicated.
And the looming maturity wall isn’t the only problem. Among the reassuring aspects of this year’s junk boom is that low-rated companies were using cash to refinance rather than to juice returns or fund buyouts. Moody’s reports that this is changing, as these companies start believing in the economic recovery and exploiting the free-flowing liquidity to undo their recent balance sheet improvements:
This growing confidence is leading to a clear pickup in mergers and acquisitions, dividend recapitalizations, share repurchases and other transactions that could be deleterious to corporate credit, particularly if capital markets are in any way spooked in the future – say, by the looming wall of maturities. Corporate America may be setting itself up for another default cycle, even if the economic recovery stays on track.
In this way, these companies are behaving no differently than other non-financial corporates.
So there are conflicting signals here, with an obvious discrepancy between the favourable short-term picture and the troubling longer-term threats. It’s also hard to know how the market for high yield will react to different swings in the economy. Or, for that matter, to changes in policy.
How would investors react to an accelerated recovery? Would they continue showing such strong demand for high yield bonds, as formerly junk-rated companies graduate to investment grade status, or would the resulting higher interest rates send them running to other asset classes?
It may be the case that, as in the muni markets, high yield will eventually enter a period of uncertainty as the maturity wall approaches — and perhaps this will make it a true bond-picker’s market, where the performance differential between the right credit selections and the wrong will widen.
We’re not sure, and again, we remain confused as to how to read some of these signals. The arguments both for and against the continuation of the HY boom seem persuasive.
We also recognise that our default setting on this market has been that of an extreme sceptic. Having presented some of the potential downsides, we’ve reached out to a couple of HY bulls to get their take and will report back later.
Related links:
Cash-hoarding corps – FT Alphaville
Another milestone for junk debt – FT Alphaville