UPDATE: Here's why junk bonds could suffer a big hit
By Jeff Reeves, MarketWatch
Lack of a big risk-premium is a warning sign
Just about two years ago, in the fourth-quarter of 2015, perhaps the biggest news on Wall Street was the turmoil in the junk-bond market.
A sharp downturn in the price of oil at that time left many energy companies unable to service their debt. Standard & Poor's warned that as much as 50% (http://money.cnn.com/2015/12/10/investing/oil-prices-bond-defaults/index.html) of the energy sector could default, and one MarketWatch writer warned that"it's 2008 all over again." (http://www.marketwatch.com/story/credit-spreads-seem-to-think-its-2008-again-2015-12-22)
Junk-bond funds that had chased this high-yield asset class found themselves in a tight spot. Indeed, Third Avenue's Focused Credit Fund (https://www.nytimes.com/2015/12/11/business/dealbook/high-yield-fund-blocks-investor-withdrawals.html?_r=0) was forced to liquidate and close after the investment vehicle was swamped by redemption requests.
Have you forgotten all that?
Most investors apparently have. After all, junk-bond yields hit record lows (http://www.foxbusiness.com/features/2017/05/11/junk-bond-yields-hit-record-lows.html) in early 2017 on the theory that the "reflation trade" would lift growth and make it easier for companies to pay what they owed. Oil prices have been relatively stable, and a "risk on" market this year continues to keep most folks content
But does that mean investors should continue eagerly buying junk bonds? Or should they prepare for another high-yield credit crisis?
To be sure, the junk bond market is perhaps as healthy as it could be in the current economic environment.
According to the BofA Merrill Lynch US High Yield index (https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY) tracked by the Federal Reserve, junk bonds are yielding around 5.5% at present -- the lowest level since 2014, and almost half the peak yields of 9.5% seen in mid-2016 -- thanks to strong demand. In fact, a recent Bloomberg report (https://www.bloomberg.com/news/articles/2017-09-19/juiciest-junk-bonds-going-extinct-with-approach-of-autumn-calls) shows that some companies that issued debt at higher rates are now racing to repay those bonds early and re-issue junk bonds at the present lower rate.
That's a pretty good indication that investors are still high on this asset class. Furthermore, after the wave of energy defaults a few years ago forced out the weakest hands and stable oil prices have brought some short-term relief, defaults haven't been as much of a red flag in 2017. In fact, recent data from Moody's showed the junk-bond default rate at its lowest level (https://www.reuters.com/article/global-bonds-defaults/global-junk-bond-august-default-rate-lowest-since-2015-moodys-idUSL2N1LT23W) since October 2015.
Of course, anyone who has been around the block on Wall Street should know that just because investors are readily buying an asset doesn't mean a crash can't happen. What's perhaps more important than simply gauging demand, then, is to look at the fundamentals of the junk bond market.
For instance, while junk bond yields have fallen to around 5.5%, it's important to look at the "spread," or risk premium, being paid for these risky assets vs. high quality bonds.
In reality, that risk premium isn't much of a premium at all. The 10-year Treasury note is yielding roughly 2.3%, just 300 to 350 basis points lower than the typical junk-bond yield. That's well below a "normal" spread north of 400 basis points. And save for a brief period in 2014, the spread currently is the lowest since the pre-crisis days of 2008.
That's a troubling sign when investors are willing to take extra risk without much extra potential reward. These are junk bonds for a reason, after all.
Furthermore, the inverse relationship between price and yield means the only way junk-bond investors will get paid is via distributions. Does anyone think it's realistic for junk-bond yields to go lower from here and push principal values significantly higher?
Yes, default rates have rolled back a bit. And yes, it's possible that low junk-bond yields remain stable and investors can just keep clipping their coupons. But there are serious risks here.
All this is shaking out even as we enter an era of theoretically tighter monetary policy. And that adds an added layer of risk and uncertainty. In the bleak words (http://money.cnn.com/2015/04/20/investing/jeffrey-gundlach-crisis-junk-bonds/index.html) of bond guru Jeff Gundlach of DoubleLine Capital, ""The entire life of the junk bond market has been during secularly declining interest rates. It's like a summer insect. You can't talk about ice with a summer insect."
For now, it appears that summer is here. Because while there's a lot of talk about how the Federal Reserve is moving to raise rates, the bond market itself isn't really seeing higher rates -- at least on the long end of the yield curve.
Yes, short-duration bonds are now yielding significantly more -- 1.3% or so on a one-year U.S. government bond, according to the Treasury, compared to a yield of less than 0.3% (https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2015) during much of 2015. However, the 10-year is pretty much on par with its 2015 yields despite all the intervening rate hikes, and the 30-year is actually yielding lower now than it was in January 2017
It's telling that many institutional investors and Wall Street bigwigs are preparing for this situation to get dicey and preparing for the moment when yields do rise. There's Gundlach sounding the alarm, for one. There's also Europe's largest high-yield bond fund (https://www.bloomberg.com/news/articles/2017-09-20/biggest-european-junk-bond-fund-says-now-is-time-to-be-fearful) pulling back on concerns that higher interest rates could create problems for the junk-bond market. And then there are hedge-fund managers such as Boaz Weinstein of Saba Capital who's actually going short junk (https://www.cnbc.com/2017/09/12/hedge-fund-manager-boaz-weinstein-starkly-warns-investors-to-avoid-junk-bonds.html) at these prices.
Even yield-starved investors are weighing their options. Recent reports (https://www.bloomberg.com/news/articles/2017-09-20/investors-fleeing-junk-credit-see-less-risk-in-emerging-markets) indicate tremendous inflows into emerging-market debt as those looking for income seek other options -- even if they are as tenuous or even more risky than junk bonds.
There's no way to know for certain how this will end. But investors who stay in junk bonds should at least remember the pain of 2015 and consider the risks of this asset class before becoming overly dependent on it.
-Jeff Reeves; 415-439-6400; AskNewswires@dowjones.com
(END) Dow Jones Newswires