January 4, 2013 6:18 pm

US junk-rated debt yields dip below 6%

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The average yield on US junk-rated debt fell below 6 per cent for the first time this week, setting a new milestone in a multi-year rally sparked by investors’ voracious demand for yield.

Holding junk bonds at these lower yields may not fully compensate investors for the risks associated with lower-rated debt. Fund managers such as Pimco and BlackRock warned last year that valuations in some cases had become extreme, prompting them to reduce their exposure to the bonds.

The double-digit returns from junk bonds last year are still luring investors at a time when corporate default rates are below historical averages, analysts said.

“Even with average yields below 6 per cent, high yield is literally the only fixed income asset class that will give you some income,” said James Lee, senior high yield analyst with Calvert Investments.

“We need major disruptions in the fixed income markets and shifts in the Treasury curve, and a spike in defaults to see a serious threat to high yield.”

Average yields on US junk bonds fell to a record low of 5.89 per cent on Thursday, as spreads over comparable Treasuries tightened by roughly 200 basis points in the past year, according to Barclays indices.

The drop in yields came as risk appetite jumped in the wake of a compromise in Washington to avert the fiscal cliff. Not even a sell-off in Treasuries, which pushed yields on the 10-year note to seven month highs, deterred investors.

The unabated demand for junk debt is also an indication of investors’ growing comfort with companies with lower credit quality, and also with the riskier lending practices that were common during the credit boom.

Companies took notice of the demand and sold a record amount of junk bonds in 2012, with the sales of triple-C rated paper – deep in junk territory – climbing 63 per cent, according to Dealogic.

The Federal Reserve’s launch of another round of quantitative easing in late September provided an extra incentive to junk-rated companies to come to market to refinance or lock in new funding at low interest rates.

For 2013, sales of junk debt are expected to remain strong, even after minutes of the Fed’s December meeting released on Thursday hinted at a potential end of asset purchases.

“If the Fed had come and unambiguously announced the end of QE3, then we could see a bigger impact on high yield,” said Ben Burton, managing director in leveraged finance syndicate at Barclays. “But the indication is that the central bank will continue to stay behind markets for now.

Barclays estimates total sales of high-yield debt in the US may reach $300bn this year.

“Average high yields below 6 per cent is something these markets have never seen,” Mr Burton said. “Issuers are going to take advantage of that. The environment is very favourable to them.”

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