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Companies have taken advantage of investors growing willingness to buy
speculative bonds
WHEN cash deposits pay virtually zero, investors have an incentive to take
risks in search of higher returns. That has been good news for the high-yield,
or junk, bond market, where companies with poor credit ratings (below the
investment-grade threshold of BBB) turn for finance. Many companies can now
borrow at rates that governments would have been pleased to achieve two decades
ago. Indeed, so low have borrowing costs fallen that some wags have dubbed the
market the asset class formerly known as high-yield .
Until the hiatus related to the budget crisis in America, companies were
rushing to take advantage of this financing opportunity. In the first nine
months of the year global high-yield-bond issuance reached $378.2 billion, up
by 27% on the same period in 2012, according to Dealogic, a financial-data
firm. Sprint, an American telecoms company, raised $6.5 billion in two
simultaneous bond issues, the largest-ever junk financing.
Low rates will not last forever, so companies are keen to take advantage of
what might be an historic opportunity. And investors have been happy to take
the extra yields on offer, given the positive returns achieved since 2009.
In America, the modern high-yield-bond market dates back to the 1980s. Until
then, high-yield bonds were usually fallen angels companies which previously
had an investment-grade credit rating but had seen their finances suffer. But
Michael Milken and his team at Drexel Burnham Lambert, an investment bank,
discovered there was a market for high-yield debt from new issuers, often in
connection with companies making takeover bids.
The market is now huge. A study by Russell, a consultancy, estimated its total
size at $1.7 trillion. Almost half of all the corporate bonds rated by Standard
& Poor s are classed as speculative, a polite term for junk. Part of this is
down to fashion; companies have been urged to return spare cash to shareholders
and to make their balance-sheets more efficient by taking advantage of the tax
deductibility of interest payments.
Another big boost to the market has been the broadening of its base beyond
America. According to Fraser Lundie, a high-yield-bond manager at Hermes,
America comprised 89% of the market in 1998; now it forms just 57%. Europe has
gone from 3% of the market to 27%.
The rise of high-yield bonds has been handy for European companies in the wake
of the financial crisis, as many banks have been seeking to shrink their
balance-sheets, and have been less willing to offer loans. Historically,
European companies have been much more dependent on bank finance than their
American counterparts. They also used to be warier of seeing their bonds
classed as junk.
Low rates have been good for the market in another way. They have enabled
companies to refinance their debt cheaply, and so pushed back the nettlesome
day when their finances will be squeezed by higher borrowing costs. A few years
ago there was a worry that a lot of debt would need to be refinanced in 2012
and 2013; now the refinancing hump will not come until 2017 and 2018.
A long period of cheap finance makes it less likely that issuers will be forced
to default in the short term, and the reduced likelihood of default makes it
more attractive for investors to hold bonds. In the wake of Lehman s collapse,
the spread (or excess interest rate) on junk bonds rose so far that it implied
default on a scale not seen since the Great Depression. But after a brief spike
to 13.7% in 2009 (see chart), the default rate on global high-yield bonds
dropped steadily and was just 2.8% in September, according to Moody s, another
ratings agency.
But not all is sunny in the high-yield world. Although the market has doubled
or tripled in size since 2008, liquidity has diminished. Regulatory
restrictions mean that banks no longer hold as much inventory in the form of
bonds; since 2002, there has been a decline of almost three-quarters. PIMCO, a
huge bond-fund manager, said in a recent report, We see reduced liquidity as
an important secular (three- to five-year) trend. It is an unintended
consequence of the deleveraging and re-regulation of banks globally. It will
result in higher volatility in times of stress. In other words, if investors
ever lose their current enthusiasm for high-yield bonds, they will find it much
harder, and probably costlier, to offload them.
Meanwhile, the growing enthusiasm for high-yield bonds is likely to diminish
the returns they offer. In the past investors typically bought junk bonds at a
discount to their face value; they hoped that the profits on bonds that were
repaid at maturity (and kept paying interest in the interim) would offset the
losses on the few issuers that defaulted. Yet in May this year the average
price of a high-yield bond reached 6% above face value, according to Mr Lundie.
Holding a bond until maturity will thus result in a capital loss, although
investors may still profit from interest.
Worse, many bonds perhaps two-thirds or three-quarters of the market have a
call option attached to them that allows the issuer to repay the debt if it
reaches a certain price. That allows issuers to take advantage of growing
optimism about their prospects to reissue bonds at lower interest.
Such call options skew the risk-reward trade-off. If a bond gets close to the
callable price, it is unlikely to rise much further: who would bid 110 cents
for a bond that can be redeemed at 104? On the other hand, if the company hits
hard times (and high-yield issuers are by definition more risky), the bond
could fall quite sharply in price. So investors face a limited upside and a big
downside.
That has tended to push investors towards ever riskier assets, such as
CCC-rated bonds the lowest category excluding those issuers that have already
defaulted. David Newman of Rogge Global Partners, a fund-management firm,
reckons that such bonds are now probably overpriced, given the risks involved.
It is in the nature of the bond markets that, when conditions are good,
investors get more relaxed about credit quality. Some observers think that the
risks of high-yield bonds are being systematically underestimated. The spreads
paid by high-yield issuers are low relative to the historical average, although
they are more than sufficient to compensate investors given the low level of
defaults. If central banks start raising interest rates to deal with a
resurgence of inflation, or if the global economy slips back into recession,
junk-bond investors may suffer a nasty shock. But for the moment they are
enjoying the ride.