The price for junk bonds’ Golden Age will be slower growth

Think of junk bonds and you probably think of the 1980s. The era when Michael Milken of Drexel Burnham Lambert created the market for high-yield bonds – from risky companies, which investors bought because of the high yield on offer – passed into popular culture. The bonds that powered corporate raiders found immortality in great books, an iconic film with Michael Douglas, and even a ballet.

But for junk bonds, the Milken era was nothing compared to the success they are enjoying today. These are the glory days. Their yields have never been lower and neither have their defaults.

However, today’s situation is profoundly different. If the 1980s boom was fuelled by greed and a reckless denial of risk, then this boom is driven by fear, and a prudent desire to maximise income safely. And while the 1980s boom ended with a bang – arrests and prison for the leading junk financiers, a market sell-off, a wave of defaults, and a recession – the chances are that this one will end with a whimper.

Let us look first at yields. B-rated US bonds – relatively low-quality junk – yielded more than 18 per cent in 1990. They now yield little over 6 per cent. This is the lowest on record, and less than would usually be expected from a humble bank savings account.

Higher-quality junk bonds yield even less, and Barclays’ high-yield index for the US, a popular benchmark, is now yielding less than 5 per cent for the first time ever. The spread, or the extra yield paid, between junk and high-grade corporate bonds has also narrowed to levels which historically have signalled the excessive optimism that comes before a sell-off.

These bonds pay a higher yield to compensate for greater risk; but these yields are now lower than the dividend yields paid out by some large and well-established companies on their stocks.

That sounds crazy. But bear in mind that the only risk with a high-yield bond, if the investor carries it until it matures, is that the company defaults. And that risk has never been lower. The results of this year’s Deutsche Bank Historical Defaults Study, carried out annually for the last 15 years, show high-yield defaults dropping to historic lows.

In 1990, at the end of the sector’s first great era of excess, 15.9 per cent of US junk bonds defaulted. This cycle has been different. Defaults peaked at 7.4 per cent in 2009, and ran at only 0.5 per cent last year.

The average default rate over the past 10 years, which saw first the most insanely overpriced bubble in credit ever seen, then the Great Recession, has been only 1.6 per cent. Going back to the dawn of the sector in 1983, the average default rate has been 5.3 per cent.

Default rates used to correlate closely with the economic cycle; bad times meant more defaults. But no more.

What can explain this? When interest rates are held artificially low, weak and unprofitable companies can refinance their debt, when once they would have been forced to default. The kinder, gentler interest rate environment has made for a kinder, gentler capitalism, where the weak are not forced out, but instead can finance themselves cheaply for years into the future.

Capitalism thrives on creative destruction, the efficiency and dynamism that comes when some companies are forced to the wall

Looking at the maturity profile for high-yield debt (when it will come due), the Deutsche Bank report shows that most debt in the US now on issue will not come due until 2018 or later. So benign financing conditions are locked in, even if a further financial crisis or economic slump intervenes.

This is unhealthy. Capitalism thrives on creative destruction, the efficiency and dynamism that comes when some companies are forced to the wall. Without such destruction, the risk is that zombie companies will suck up capital that could be better deployed elsewhere.

How long can this carry on? Returns to investors (who appear largely to be institutions, rather than retail investors dipping their toe in the sector) have long looked like equity returns.

Since the day Lehman Brothers fell in September 2008, high-yield credit has actually outperformed the S&P 500 stock index. Since the stock market low in March 2009, the US iBoxx high-yield index has gained 116 per cent.

All of this appears to scream out for a correction. Under normal logic, such low credit rates would encourage companies to borrow more, thus improving their equity value while damaging their credit.

But we are not operating under normal logic. While base interest rates remain low, the yields on high-yield debt remain appealing, and the risks of default remain low. In the short-term, while monetary policy and low growth keep interest rates low, it is hard to see a correction.

Such low default rates suggest that capital is flowing to the wrong places. The price for junk bonds’ Golden Age will eventually be paid in slower growth.