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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