An Appetite for Junk

Companies have taken advantage of investors’ growing willingness to buy speculative bonds.

When cash deposits pay virtually zero, investors have an incentive to take risks in search of higher returns. That has been good news for the high-yield, or junk, bond market, where companies with poor credit ratings (below the investment-grade threshold of BBB) turn for finance. Many companies can now borrow at rates that governments would have been pleased to achieve two decades ago. Indeed, so low have borrowing costs fallen that some wags have dubbed the market “the asset class formerly known as high-yield.”

Until the hiatus related to the budget crisis in America, companies were rushing to take advantage of this financing opportunity. In the first nine months of the year global high-yield-bond issuance reached $378.2 billion, up by 27 percent on the same period in 2012, according to Dealogic, a financial-data firm. Sprint, a U.S. telecoms company, raised $6.5 billion in two simultaneous bond issues, the largest-ever junk financing.

Low rates will not last forever, so companies are keen to take advantage of what might be an historic opportunity. And investors have been happy to take the extra yields on offer, given the positive returns achieved since 2009.

In America, the modern high-yield-bond market dates back to the 1980s. Until then, high-yield bonds were usually “fallen angels” — companies which previously had an investment-grade credit rating but had seen their finances suffer. But Michael Milken and his team at Drexel Burnham Lambert, an investment bank, discovered there was a market for high-yield debt from new issuers, often in connection with companies making takeover bids.

chart of junk bond yieldsThe market is now huge. A study by Russell, a consultancy, estimated its total size at $1.7 trillion. Almost half of all the corporate bonds rated by Standard & Poor’s are classed as speculative, a polite term for junk. Part of this is down to fashion; companies have been urged to return spare cash to shareholders and to make their balance-sheets more efficient by taking advantage of the tax deductibility of interest payments.

Another big boost to the market has been the broadening of its base beyond America. According to Fraser Lundie, a high-yield-bond manager at Hermes, America comprised 89 percent of the market in 1998; now it forms just 57%. Europe has gone from 3% of the market to 27%.

The rise of high-yield bonds has been handy for European companies in the wake of the financial crisis, as many banks have been seeking to shrink their balance-sheets, and have been less willing to offer loans. Historically, European companies have been much more dependent on bank finance than their American counterparts. They also used to be warier of seeing their bonds classed as junk.

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