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High-yield bonds - An appetite for junk

2013-10-22 07:59:48

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.