Junk bonds: Easy money has been kind to risky companies and their lenders. Firms like Clearwire Communications and HCA found critical funding in 2010, while investors in their bonds have enjoyed stellar double-digit returns, with the Bank of America Merrill Lynch high yield index returning nearly 14 per cent by early December. So much money sloshing around the global financial system, however, also makes for outsized distortions and in 2011 could trigger a junk bond correction.
The overall high yield market, essentially all corporate bonds rated below BBB-minus on the rating agencies' standard scale, isn't flashing bubble warnings. Though risk premiums in excess of benchmark Treasury yields have narrowed dramatically from their fear-driven heights a few years ago, for the asset class as a whole they're more or less in line with the historical average of six percentage points.
Yet the dusty bottom shelf of the debt junkyard is telling a different story. In early December, risk premiums for CCC-rated debt were nearly 3 percentage points lower than their historical average of nearly 11 percentage points, according to BNP Paribas. That matters when this highly speculative class of debt represents almost 20 percent of the total junk bond market.
When times are good - and they’ve been very good to risky assets in the last two years - CCC-rated debt can be a star performer. With funds available to refinance debt, one big risk is removed for highly-leveraged borrowers. And with underlying interest rates ultra-low, investors fancy the relatively high yields available at the risky end of the spectrum, even if they don’t look as fat as they did. The problems begin when market sentiment turns and the dash for trash turns into a rush for the exit.
Leveraged companies typically need to grow into oversized debt loads, which on average means they do better in an expanding economy. So investors hoping for another good year in the high-yield market need growth. But they need a Goldilocks outcome: especially in the narrow CCC category, they could run into trouble if the economy gets too hot as well as too cold.
Disappointingly low growth would hurt revenue and increase the risk of default, with the riskiest junk borrowers first in line to fail. Moody’s is forecasting that just 1.8 percent of all corporate debt globally will default in the year to November 2011, down from 2.9 percent this year and 13.6 percent in 2009. If growth fails to pick up further, those numbers could rise again.
At the same time, higher-than-expected growth would spur investor appetite for equities, just a short step down the capital structure from the lowest-rated debt. That could make CCC paper less attractive - as could the rising interest rates that might well accompany healthy growth, because less risky, higher-rated bonds would suddenly deliver better yields than they have been doing.
In short, the riskiest end of the high yield spectrum looks priced for something like perfection. Euro zone troubles, Federal Reserve policy changes, a swing toward austerity in the U.S. Congress or an upside growth surprise could all upset the balance. All of which means that those investors reaching deepest into the junk bond garbage pail in 2011 could find something bites back.