Investors could be forgiven for thinking that after Britain’s shock decision to leave the EU and upend the geopolitical status quo, the riskiest parts of the debt markets might have registered some concern.
But no, the yield on junk bonds in Europe and the US has sunk to levels seen before last summer’s market turmoil.
The market-cap weighted yield on bonds included in the Bank of America Merrill Lynch US high-yield index is 6.54 per cent — the last time it was lower was in June of last year before the market was rocked by worries about the extent of defaults brought on by the end of the shale gas boom.
The euro equivalent stands at 3.52 per cent, close to its historical lows — the only time junk bonds yielded less was for just a few days in June 2014.
As falling yields imply higher prices, the question for investors now is whether junk has become overvalued. Are investors compensated for the risks they take or has quantitative easing distorted the market so much that it can no longer price “risk” accurately?
One reason is central banks’ programmes of asset purchases. The low sovereign bond yields that have resulted transmit themselves to high-yield bonds, as junk pays a “spread” above the so-called risk-free rate.
In Europe, many government bonds now trade with a negative yield, helping drag down the rate on junk bonds further. “Today you have close to almost 50 per cent of the European high-yield market yielding 2 per cent or less,” says Andrew Jessop, head of global high-yield at Pimco.
But spreads have also compressed as quantitative easing has pushed yield-hungry investors into riskier parts of the bond markets — at present around 18 per cent of the world’s yield comes from US junk bonds despite the assets only accounting for 4 per cent of the total bond market, according to an analysis by TwentyFour Asset Management of the Barclays Multiverse index.
This influx of exiles from investment-grade has helped lower the spread on European speculative-grade bonds to 405 basis points, according to the BofA index, around the same levels as June in 2016.
In the US, the average spread of bonds included in the BofA index is 534bp, down from over 850bp in February.
Is the movement in US junk justified? “Our view today is that it is more fairly valued,” says Mr Jessop. In the US many of the more distressed commodity companies have already filed for bankruptcy or reduced their debt levels and away from commodities-exposed companies we are in an “unusually low default rate environment”, he says.
Default rates on speculative-grade bonds are currently running at 5.5 per cent in the US; in Europe they are even lower at just 2.6 per cent, according to the rating agency Moody’s.
While the asset purchases of the European Central Bank and the Bank of England are providing a “technical” boost to the market, the “fundamentals” are still OK, says Russell Taylor, a senior research analyst with JPMorgan Asset Management who specialises in European high-yield.
“The market hasn’t gone through a period of levering up because growth was never good enough to support that,” he says. “We have never reached that stage in the cycle where companies took on debt.”
The number of defaults globally increased to 102 in July, the highest level since the 2009 recession. Most of these were concentrated in commodity companies: 49 were in the oil and gas sector and 13 were for metals and mining business. Now, as oil and metal prices have rebounded, bonds of companies working in these sectors have rallied too.
This extraordinarily low rate of default means that anyone considering buying high-yield bonds faces an asymmetric problem: defaults are much more likely to increase than decrease — the credit cycle may have topped out.
“Default rates in Europe have been increasing slowly over the past two years although they are still below the long-term average,” says Richard Etheridge, an associate managing director with Moody’s. “Overall, about half of our industry outlooks are still stable, with slightly more sectors having a negative outlook than positive.”
And even if defaults remain low and investors are certain they will get most of their money back there is another question they must ask: where is the market going?
With continuing high demand for income-yielding assets and little new bond supply, any jump in spreads is unlikely to come from within the junk bond market itself, says Justin Jewell, co-head of global leveraged finance at BlueBay.
Bondholders have spent nearly a decade benefiting from the largesse of central banks and the need for an ageing society to secure income, but while this is unlikely to last forever it is, by definition, difficult to invest for the unexpected.
“The impetus for a correction will have to come from somewhere external: something that impacts risk premia more broadly. It needs to be something like the Italian banking system, political issues or a rates shock, but these are all not internal,” Mr Jewell says.
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