Tuesday, January 12, 2016

Junk Bond Bust by Guest Blogger Buck Klemkosky

There are problems in the junkyard. Liquidation of the largest mutual fund since 2008, Third Avenue’s $800b Focused Credit Fund, has intensified concerns about the health of the high-yield bond market.  Third Avenue had invested in high-risk illiquid bonds and as redemptions poured in the fund sold liquid bonds first but at the end could not sell the $800b of illiquid bonds and halted redemptions until assets can be sold. 

Another high-yield fund also stopped redemptions and one other liquidated. This was a wake-up call for investors who had been chasing yield without assessing the potential risk of high-yield bonds. The amount of money invested in high-yield bond funds has quadrupled since 2009.

High-yield, high-risk bonds are commonly referred to as junk bonds. People who work and invest in this area of the bond market would prefer the high-yield label but junk is used as often as not. Bonds are rated investment grade or speculative. Investment-grade bonds are further categorized into high-grade (AAA and AA ratings) and medium-grade (A and BBB ratings). High-yield bonds (rated BB or B or CCC) are considered speculative with only moderate protection of principal and interest. Bonds can be rated lower than CCC but usually not at issuance.

There are only three AAA-rated corporations left in the U.S.: Johnson & Johnson, Exxon-Mobile and Microsoft. Twenty-five years ago there were nearly 100 U.S. companies with AAA ratings so they are a dying breed. There has been a long-term downgrading of corporate bonds globally; for example, in 2015 more than $1t of corporate bonds have been downgraded and less than $500 B upgraded in the U.S. alone.

Prior to the 1980s, only investment-grade bonds could be issued. Any bonds rated lower than BBB had been downgraded. Mike Milken of Drexel Burnham fame started the junk-bond revolution by convincing investors to buy high-yield bonds at issuance. He has long since departed the industry as has Drexel Burnham but the high-yield bond market continues to thrive. High-yield bond issuance has set records the past five years as has the issuance of investment-grade corporate bonds.

One result of the record amount of high-yield bond issuance and consistent downgrading of investment-grade bonds is today $2t of global corporate bonds are rated speculative or junk. Corporations have been motivated to issue bonds because of low interest rates and tax advantages while investors have chased yield because high-yield bonds provide 4-5% annual yield more than investment-grade bonds. Recently AA-rated bonds yielded 2.61%, BBB-rated 4.27% and high-yield 8.5-8.8%, up from 5.8% earlier in 2015. In the bond markets, the higher the risk, the higher the return. If you really have an appetite for risk, the CCC-rated bonds yield over 18%. However, as junk-bond yields have increased and prices declined, they will suffer negative returns for the first time since 2008. A popular high-yield bond index has fallen 13.6% since mid-April 2015, prompting investor selling.

What is the downside of having $2t of corporate bonds rated junk? Evidence shows that the probability of default is much higher for junk bonds; over a 30-year period, 3.8% of these bonds defaulted annually. In 2015, the default rate was 2.6% versus 2.1% in 2014. The default rate is expected to be above 4% in 2016. During periods of crisis such as 2007-2009, the default rate skyrocketed to 15%. About 25% of high-yield bonds have been issued by energy, mining and commodity-based companies which are now experiencing financial stress. 111 companies have defaulted on $80b of debt in 2015, the highest number since 2009. High-yield promised returns look appealing in a low-interest rate world; returns after default don’t look nearly as attractive as promised yields. Unfortunately many investors have chased yields without fully understanding the risk that entails.

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