November 5, 2012

Chart of the Week: Can We Still Call it “High-Yield” Debt?

by Alpha Now Research Team

The junk bond, or high-yield bond, universe has seen yields decline steadily in both absolute and relative terms, creating a financing bonanza for companies whose credit rating is below investment grade and for the banks underwriting their debt issuance. But questions about corporate earnings may provoke questions about whether investors’ hunger for interest income has driven valuations too high, and yields too low.

Yields on so-called junk bonds have hit almost surreally low levels over the course of 2012, due to a combination of the intense hunger for income on the part of investors and the equally astonishing level of yields on Treasury securities. The spread between those ‘risk free’ Treasury notes and their junk bond counterparts fell in mid-October to only about 531 basis points, meaning that many companies with a below-investment grade rating were able to snag financing on terms that an investment-grade issuer would have been happy to acquire throughout much of the last decade. An average ‘junk bond’ issuer (as measured by the Bank of America Merrill Lynch U.S. High Yield Master II Index) can expect to raise new funds in exchange for an annual yield of less than 7% as of the end of October.

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This week’s Chart of the Week captures that trend, including the general trend toward still-lower yields over the course of much of 2012, a period in which the Federal Reserve policymakers kept key lending rates unchanged and during which investors’ barometers have swung wildly between ‘risk on ‘ and ‘risk off’ readings. While on any given week, investors can yank money out of high-yield bond funds and re-invest it, generally the trend seems to have remained in favor of maintaining a slowly increasing allocation to this asset class. For instance, spreads between high-yield bonds and Treasuries widened in mid-September – only to contract once more within a few weeks.

To date, at least, the fact that rating agencies believe that these companies have a higher risk of default and thus should face a penalty in terms of the returns they provide to investors willing to run that risk seems not to be reflected in reality. The actual default rate by high-yield bond issuers today hovers just below 3%; the historical average is about 50% higher.

Still, as the chart highlights, this remains a higher-risk market for investors to navigate, particularly since, as we have discussed extensively on AlphaNow, a growing number of companies are struggling in vain to post healthy gains in both revenues and earnings. To the extent that wary investors respond to third-quarter earnings announcements and warnings of what lies ahead for the fourth quarter and for 2013 by trimming their holdings of equities, the same is likely to be true of junk bonds. And while the S&P 500 index remains at a relatively moderate valuation relative to its history, that of the junk bond universe is more aggressively priced.

Indeed, even if the risk of default remains low, perhaps the biggest risk facing investors in this segment of the markets is simply the fact that, as this week’s Chart of the Week demonstrates, the high-yield bond market’s yields no longer seem to justify their moniker.

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