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A Junk-Bond Bubble?

Neither issuers nor investors are worrying much about defaults.

The trailing 12-month default rate on U.S. high-yield debt is very low — 1.8 percent as of April, according to Fitch Ratings, “extending a three-year run” of being well below the historical annual average of 4.6 percent.

Instead of expecting the rate of borrower defaults to move back toward the historical average, though, investors and issuers in the corporate bond and institutional loan markets are acting like the good times will continue unabated. The situation is causing some of the rating agencies to start ringing the alarm bells.

On Wednesday, Fitch Ratings issued a report saying that the low interest-rate environment is increasing investors’ “risk receptivity” – to earn decent yield on their money, they’re willing to lend to riskier companies. Sixty-six percent of highly speculative (CCC-rated or lower) bond-market volume was recently trading above par, Fitch points out, and the equity value of a group of 172 B-rated companies has increased 22 percent so far in 2013.

But risk receptivity isn’t merely represented by the fact that investors aren’t buying. It’s also evident in the lack of covenants attached to speculative-grade debt. Institutional “covenant-lite” loan volume was near $80 billion in the first quarter, according to Moody’s Investors Service. That’s equal to the total for all of 2012. Covenant-lite debt comes with fewer or no restrictions on things like collateral, payment terms and earnings performance. Similarly, high-yield bond issuance is up 16 percent in 2013.

A Moody’s report, issued last week, said “robust issuance” of both covenant-lite loans and high-yield bonds with weak protections suggest a “covenant bubble” that could leave fixed-income investors exposed to losses in a credit-cycle downturn. But investors continue to gobble up speculative-grade debt.

As Fitch points out, the surge in asset values from Fed policy buttress a low-default-rate environment. But “the same easy money conditions that have been an aid in the recovery can also begin to contribute more significantly to risk buildup.”

As historical proof, Fitch points to the period after the 2001-2002 downturn, when the impact of loose monetary policy brought transactions to market that had “aggressive terms and leverage levels.” Credit quality deteriorated, but even in 2007, with corporate profits strained, CCC issuance hit record highs. The “heated funding environment” kept the default rate below 1 percent, Fitch says.

“The low default rate perpetuated the cycle of aggressive transactions and was in the end a red flag of systemic risk rising rather than shrinking,” according to the Fitch report.

Institutional investors and lenders are not the only ones who may be underestimating longer-term default risk. A survey of 401 publicly rated companies last autumn by Debt Compliance Services (DCS) found that non-investment-grade companies are seriously underestimating the long-term debt- default risk of their own companies and of companies that have equivalent credit ratings.

Executives’ expectations of five-year default probability were compared with a March study of 30 years of corporate defaults by Standard & Poor’s. DCS found that corporate executives surveyed estimated a 5 percent five-year default rate for BB-rate companies – that is, speculative grade. But the S&P analysis showed the actual cumulative five-year default rate has been historically higher, at 8.4 percent. Executives estimated a 4.2 percent default rate for B-rated companies, but the historical rate has been more than 20 percent.

By underestimating long-term risk, companies are “likely to implement inadequate debt compliance practices,” notes DCS in a report accompanying the survey.

Even if risky credits don’t default in the next few years, downgrades are likely. Speculative-grade companies have had a higher probability of a ratings downgrade within five years, according to S&P’s calculations. Almost half of of  BB-rated issuers historically have experienced downgrades within five years, as have 44 percent of B-rated ones, according to S&P.

But in the near term, with the Federal Reserve’s highly accommodative monetary policies in effect, none of the rating agencies are expecting any change in investor appetite for high-risk bonds and loans.

If there is an eventual reckoning, says Moody’s, it probably won’t come in the next 12 months. Moody’s proprietary indexes “all point to a favorable outlook for speculate-grade companies for at least the next year, with solid liquidity and few defaults,” the ratings agency says. However, it notes, “conditions could change suddenly.”

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