May 8 2014, 3:33pm CDT | by Forbes
Two weeks ago French cable company, Numericable Group (NUM.PA), raised $11 billion dollars in the high yield or “junk bond” market. Investor hunger for this offering was so strong that the company raised $2.8 billion more than it originally sought. This is the largest junk bond offering on record and it came in a series of tranches with yields varying between 4.875% for five year bonds and 6.50% for ten year bonds. These bonds, issued to pay for an acquisition are likely to be rated three levels below investment grade. Whether this offering signals the top of the market for high yield bonds is yet to be seen, but investor appetite continues to be ravenous with $160 billion of high yield bonds issued so far in 2014.
It has become a major parlor game amongst financial professionals to discuss whether high yield bonds are currently in a bubble. Across the various credit classes within high yield, junk bonds returned almost 7.5% in 2013. So far, in 2014 junk bonds have continued to perform very well.
Junk bonds continue to offer spreads far above the “risk free” rate of US Treasury bonds or German Bunds of the same maturity even if the rate of absolute yield is very low for historical standards. Note that bond yields decline as the prices of bonds increase.
There are good reasons to believe that junk bonds will continue to perform well in the near term. First and foremost, the global hunt for yield continues unabated. When fixed income investment managers (hedge funds) promise returns of 10% (and more), they are implicitly using leverage, investing in high yield or more than likely both. Investment managers the world over know that they must take risk and high yield bonds offer the opportunity to earn generous spread with US high yield bonds currently offering 365 basis points of spread. The search for yield also continues to power retail inflows to high yield bond funds and ETFs. However, the distinction between institutional and retail money invested in high yield bonds can be striking as institutions typically invest in spread terms and frequently employ with hedges whereas retail investors seek yield. Due to the 30 year decline in interest rates, all types of investors continue to hunger for “predictable” returns through fixed payment instruments such as junk bonds.
The second reason to believe that high yield will provide decent returns in the near term is that the default rate for junk bond issuers continues to be very low. Fitch Ratings expects that the US high yield default rate will be between 1.5% and 2.0% in 2014 while Moody’s expects a 2.3% default rate. Remember that in the midst of the crisis in 2009, overall default rates approached 15% and for lower rated issuers the rate was closer to 40%. Low borrowing or refinancing costs, coupled with a steady if not slowly recovering US economy and highly receptive capital markets should continue to keep credit risk muted.
The third reason that junk bonds remain attractive in the near term is the perception that they are less interest rate sensitive than many other types of fixed income products. This point is somewhat dubious. The consensus economic forecast has been for gently rising interest rates as the Federal Reserve ends quantitative easing and monetary policy slowly normalizes. In many areas of the fixed income market, bond investors have been willing to accept a great deal of duration risk which is the measure of how price-sensitive a bond is to changes in interest rates. To defend against rising rates, many junk bond investors have recently purchased “low duration” high yield bond funds. These types of funds are not a complete salve to duration risk and investors frequently struggle with bond math where callability dates are being confused with maturity dates for a less than true duration risk calculation. The fact that high yield bond and US Treasuries returns have been uncorrelated is one mitigate but interest rate risk is a peril for all fixed income investments and high yield bonds as a general asset class will not fly under the radar of a surging rates environment.
So what could go wrong with the junk bond market? Something very underrated as a risk: the concentration and similarities of portfolios. As the global hunt for yield enters its 6th year and junk bonds trade a close to all time tight spreads, it should be clear that most high yield bond mutual funds and ETFs hold the same individual bonds. For example, the two largest high yield ETFs the iShares iBoxx High Yield (ticker: HYG) and SPDR Barclays High Yield (ticker: JNK) hold a very similar portfolio of junk bonds. There simply aren’t enough quality high yield bonds (Ba1 to Ba3 range) with the characteristics favored by investment managers acting under a fiduciary duty. Thus, all the long only, high quality, junk bond strategies tend to hold very similar portfolios at very similar concentrations.
If ever the bond market sold off, a vicious cycle of selling is likely to occur with these concentrated positions pushing indexes and ETFs down and forcing further selling. As a consequence, popular junk bond holdings may be far less liquid than anticipated, absent a large discount to price. Add to this, the fact that the major investment banks no longer hold large inventories of bonds due to regulatory constraints and this type of concentrated selling may be exacerbated. Accordingly, getting out of widely held junk bond positions ahead of the herd will be very important and genuinely difficult as this is a type of concentration risk has not been tested in live environments yet.
There are other potential pitfalls for junk bonds such as worsening global growth, the relative value (attractiveness) of other asset classes, and the simple fact that on a risk-to-return basis, high yield bonds simply do not pay much yield or spread. The average spread for high yield bonds is about 500 basis points. Today, US junk bonds pay 365 basis points, 27% below the historic average level. Still, today’s spread levels are far above the lows prior to the financial crisis when the junk bond spread was less than 250 basis points which suggests that there is still room for positive results.
Global macro investors would be better off allocating new funds to individual high yield bonds that are of lower credit quality – the “story” bonds rated C or worse by the ratings agencies. These types of credits are much less about, positioning, pricing and duration risk and more about the underlying corporation’s ability to improve business prospects and take advantage of the currently cheap cost of capital. Truly active investment managers that have sector expertise may also be a good starting point for new allocations. At the end of the day, investors should prefer to earn the highest yield possible and triple C rated bonds pay almost 8.0%. They don’t call it junk for nothing.
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