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Stock market fashions may come and go – at the moment they are mostly going, as biotech and internet boosters have discovered to their cost – but junk bonds seem able to sail serenely through. At least, so far. As investors dump expensive stocks in favour of cheaper ones, the resilience of junk is surprising.
Junk bond yields have been lower for only two weeks, in May last year. But investors care little, because companies seem to be able to pay back their borrowings. Defaults are close to all-time lows, and the ease of borrowing means many dodgy businesses are trusted with money for far longer than usual, reducing vulnerability to refinancing problems.
Low yields mean less compensation for the risk that defaults pick up. Even here, though, Deutsche Bank’s Jim Reid calculates that all but the lowest-rated junk bonds are offering enough extra yield above government bonds to cover a return to the average default rate of the past four decades.
The problem is not a recession and a drastic pick-up in defaults (although this would clearly be very bad news for junk bonds). Rather, it is that low default rates at a time of yields at or below nominal growth in the economy have historically coincided with low or negative returns.
Nominal GDP is being damped by low inflation, yet yields have dropped sharply in the past two years. This will be bad news for future returns if the link between the two re-establishes itself.
For the moment Mr Reid suggests junk is in a “sweet spot”, with bond yields kept down by a weak recovery which is just strong enough to avoid fears of rising defaults.
Junk bonds face obvious danger from a weaker economy, but also from a stronger. The spread over government bonds has been lower for long periods, but only by an average of 75bp. If a strong recovery leads bond yields to rise, junk bonds have only a small cushion to protect them, given default rates can hardly fall much lower.
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