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.
The 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.
Low rates have been good for the market in another way. They have enabled companies to refinance their debt cheaply, and so pushed back the nettlesome day when their finances will be squeezed by higher borrowing costs. A few years ago there was a worry that a lot of debt would need to be refinanced in 2012 and 2013; now the refinancing hump will not come until 2017 and 2018.
A long period of cheap finance makes it less likely that issuers will be forced to default in the short term, and the reduced likelihood of default makes it more attractive for investors to hold bonds. In the wake of Lehman’s collapse, the spread (or excess interest rate) on junk bonds rose so far that it implied default on a scale not seen since the Great Depression. But after a brief spike to 13.7 percent in 2009 (see chart), the default rate on global high-yield bonds dropped steadily and was just 2.8 percent in September, according to Moody’s, another ratings agency.
But not all is sunny in the high-yield world. Although the market has doubled or tripled in size since 2008, liquidity has diminished. Regulatory restrictions mean that banks no longer hold as much inventory in the form of bonds; since 2002, there has been a decline of almost three-quarters. PIMCO, a huge bond-fund manager, said in a recent report, “We see reduced liquidity as an important secular (three- to five-year) trend. It is an unintended consequence of the deleveraging and re-regulation of banks globally. It will result in higher volatility in times of stress.” In other words, if investors ever lose their current enthusiasm for high-yield bonds, they will find it much harder, and probably costlier, to offload them.
Meanwhile, the growing enthusiasm for high-yield bonds is likely to diminish the returns they offer. In the past investors typically bought junk bonds at a discount to their face value; they hoped that the profits on bonds that were repaid at maturity (and kept paying interest in the interim) would offset the losses on the few issuers that defaulted. Yet in May this year the average price of a high-yield bond reached 6 percent above face value, according to Lundie. Holding a bond until maturity will thus result in a capital loss, although investors may still profit from interest.
Worse, many bonds — perhaps two-thirds or three-quarters of the market — have a “call option” attached to them that allows the issuer to repay the debt if it reaches a certain price. That allows issuers to take advantage of growing optimism about their prospects to reissue bonds at lower interest.
Such call options skew the risk-reward trade-off. If a bond gets close to the callable price, it is unlikely to rise much further: who would bid 110 cents for a bond that can be redeemed at 104? On the other hand, if the company hits hard times (and high-yield issuers are by definition more risky), the bond could fall quite sharply in price. So investors face a limited upside and a big downside.
That has tended to push investors towards ever riskier assets, such as CCC-rated bonds — the lowest category excluding those issuers that have already defaulted. David Newman of Rogge Global Partners, a fund-management firm, reckons that such bonds are now probably overpriced, given the risks involved.
It is in the nature of the bond markets that, when conditions are good, investors get more relaxed about credit quality. Some observers think that the risks of high-yield bonds are being systematically underestimated. The spreads paid by high-yield issuers are low relative to the historical average, although they are more than sufficient to compensate investors given the low level of defaults. If central banks start raising interest rates to deal with a resurgence of inflation, or if the global economy slips back into recession, junk-bond investors may suffer a nasty shock. But for the moment they are enjoying the ride.
© The Economist Newspaper Limited, London (October 19, 2013)