Junk bonds remain persistently resilient

New debt selling at record speed

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Junk bonds, the darling of the debt markets for two years, are proving remarkably resilient.

Shrugging off unease from soaring oil prices and turmoil in the Middle East, they have enjoyed a strong start to the year.

Indeed, the yield on these corporate bonds, which are also referred to as “high-yield”, has stayed around the record lows of 6.8 per cent reached in February.

Oleg Melentyev, analyst at Bank of America Merrill Lynch, said: “There were concerns that the increased market volatility would push yields higher . . . This has not happened. High-yield is still hanging in there.”

Since the financial crisis, when yields surged above 20 per cent, investors have poured money into this type of debt. As the economy has improved and corporate defaults have plummeted, but with official interest rates remaining near zero, junk bonds have proved to be a good bet.

In 2009, US junk bonds made record returns of 57.5 per cent after record losses in 2008. Last year, the sector was also one of the best-performing asset classes, up 15.2 per cent.

So far this year, US junk bonds have given investors another 3.7 per cent, according to the BofA Merrill Lynch index.

A closer look at the performance of different types of bonds shows that the riskiest parts of the market – the debt issued by companies with the highest chance of default – have been the strongest.

The BofA Merrill Lynch index shows that triple C returns so far this year are 5 per cent. This thirst for riskier debt is also reflected in the sale of new bonds. Triple C-rated companies have been selling new bonds at the fastest annual pace ever, according to Dealogic, which began tracking the market in 1995.

Globally, these companies, which include names such as J Crew, the clothing chain, and Level 3, the communications group, have sold $9.8bn of debt this year, well above the previous year-to-date record of $5.2bn in 2007.

This reflects demand from the continued inflows into mutual funds investing in high-yield corporate bonds, as well as appetite for risk from hedge fund investors.

“In general, there used to be pretty strong resistance to accept new issuance from companies that were rated triple C,” said Martin Fridson, global credit strategist at BNP Paribas Asset Management.

“The increased role of hedge funds [in the high-yield market] has opened up a bigger market for triple Cs. Their structure can encourage them to stretch for yield because they often want to own what gives them highest yield versus their cost of capital.”

But the persistent strength of junk bonds, and the drop in yields to record lows, has raised questions about whether investors are ignoring the risks involved.

A handful of bond sales recently included two features considered particularly risky, according to Standard & Poor’s LCD, which tracks the leveraged finance markets.

One of those features was so-called Pik toggle, a popular structure before the financial crisis that gives an issuer the option to pay interest with more bonds rather than in cash. Debt was borrowed, too, to pay special dividends to companies’ owners, in a “dividend deal”. Typically, investors will accept these features from companies with ratings on the higher rungs of the junk category, but all four of these deals were rated triple C.

Even though yields are at lows, reflecting historically low official interest rates, the spread, or risk premium, to benchmark US Treasury bonds remains well above its record low.

In 2007, at the height of the credit boom, yields fell to 241 basis points over government bonds. Spreads are now at around 469bp.

It is this spread, or cushion, that continues to attract buyers. Even when interest rates rise, the income from the yield on the bonds acts as a cushion to any falls in price that result from rising rates.

Some investors say overall spreads can be misleading and overestimate the size of the cushion. Some measures of the share of the riskiest companies in indices show these are higher than in the past, although this kind of analysis can throw up different results, depending on how an index is sliced and diced.

Bonnie Baha, head of global developed credit at DoubleLine, a Los Angeles-based money manager, says there are now more riskier companies than in the past.

“If you are just looking at spreads, you can say we still have room to run, but what people fail to recognise is that the credit quality of the relevant credit indices is lower now than it was at the previous low points in credit spreads and that alters the logic,” she says. The days of the junk bull run may be numbered.

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