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January 18, 2013 7:39 pm
Did the “dash for trash” just become a full-on charge into the rubbish heap?
A rush by investors into risky, high-yielding assets such as “junk” bonds has raised fears that the cheap money poured by central banks into the financial system has encouraged bigger bets on an economic recovery.
The growing demand for higher returns in an era of historically low interest rates has triggered big inflows into some of the riskiest corners of bond market.
Prices of junk debt, or bonds issued by companies seen to be at greater risk of default than groups rated investment grade, have jumped sharply, sending yields below 6 per cent for the first time.
The move into junk comes as prices of short-dated German Bunds and US Treasuries have gone in the opposite direction. That has sent the spread of high-yield bonds over top-tier government debt almost to a five-year low this week.
In other words, investors in the part of the $10tn global corporate bond market with the highest chance of default are being paid one of the slimmest premiums over “safe” government debt for taking that risk since the boom that preceded the 2008-09 financial crisis.
Moreover, this hunt for yield has served to revive some boom-era financial instruments with relaxed credit discipline, such as “paid-in-kind” notes, as well as covenant-light bonds. Policy makers are starting to sound the alarm.
“The search for yield appears to be beginning again,” said Sir Mervyn King, governor of the Bank of England, this week. “A combination of a weak recovery and, at the same time, people searching for yield in ways that suggest risk being priced in is a disturbing position.”
Many investors are starting to agree.
“It’s almost a bit disturbing to see how people keep buying these bonds at these levels,” says Michael Mullaney, a fund manager at Fiduciary Trust. “Rewards are not there.”
The junk bond market was pioneered in the 1970s by US financier Michael Milken, prompting a boom in leveraged buyouts in the 1980s.
Deals such as the buyout of RJR Nabisco, subject of the book Barbarians at the Gate, became Wall Street legends. Mr Milken later went to jail for securities violations.
Today, the market is being driven by the global thirst for high-yielding instruments amid ultra-loose central bank monetary policy and record low borrowing costs. This has sent billions of dollars into the asset class.
“Yield is an endangered species at the moment, so investors have few options but to move into high-yield bonds,” said Michael Thompson, managing director at S&P Capital IQ.
“It’s easier to find a dinosaur roaming around Central Park than a decent yield now.”
After a strong rally in “junk” bonds last year, when yields fell nearly
2 percentage points, yields have this year already fallen nearly half a percentage point to anall-time record low of 5.7 per cent, according to Barclays’ indices. Yields move inversely to prices.
As long as central banks stay accommodating and default rates in the US and Europe remain low, many analysts believe this rally could last. Others warn, however, that the market is setting itself up for a fall.
One worry is that a short-term market shock could strike, just as it did in the summer months of 2011 and 2012 as the eurozone crisis flared.
The problem, once again, could be Europe. There are concerns that next month’s Italian elections or Spain’s fiscal woes could lead to a fresh jump in yields on the countries’ debt, possibly leading to further sovereign downgrades.
“If Spain starts to lose the ability to fund itself or the global economic recovery that the markets appear to be pricing in does not happen, investors will stampede out of high-yield in the same way they stampeded in,” says Matthew Mish, a credit strategist at UBS.
Another fear is the collapse of a second round of fiscal cliff talks in the US. Further political brinkmanship threatens to spook the markets. “The big worrying issue at the moment is the debt ceiling negotiations next month,” says Eric Capp, global head of high yield syndicate at RBS.
In the longer term, the big concern is that if global growth starts to pick up substantially towards the end of the year, hints from central banks that a rise in interest rates could be on the horizon could unsettle investors. “By far our biggest worry is the sensitivity of longer-dated high yield to expectations of future interest rate rises, and so we are focusing on buying shorter-dated credits at the moment,” says Zak Summerscale, chief investment officer at Babson Capital.
Even if risky assets such as equities and high-yielding debt continue to climb higher this year, the search for yield is pushing some investors into weaker credits, where shrinking returns may no longer justify the risk. “In a market like this, there is a risk that price discipline goes out of the window,” says David Newman, head of global high yield at Rogge Global Partners.
“Investors will need to be very happy with their credit choices to live through any volatility this year.”
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