The high-yield bond market was one of the big success stories of the post-financial crash period, posting a 58 percent return in 2009 and then a solid 15 percent in 2010. This spring, the wheels finally seemed to come off. Now, investors are asking themselves how weak the market’s fundamentals really are, and whether it could see a bounce-back later this year, depending on direction of interest rates and the economy.
In February, the spread between high-yield debt and Treasury bond yields was close to an historic low as institutional investors that normally stuck with higher-rated issuers reacted to the low interest rate environment by searching for attractive yields further down the credit scale. Defaults were also becoming rarer, partly reflecting the success of even smaller companies at rebuilding their balance sheets. Meanwhile, a growing, if volatile, European high-yield debt market was offering higher yields than U.S. issues, suggesting investors will have an even wider field to choose from in the future.
Prospects started to cool in the spring, however. Between mid-April and late June, spreads widened from a low of 453 basis points to 564. That put a damper on the new issuance calendar, which had been crowded earlier in the year. Nearly $5 billion in new high-yield issues came to market from January 1 to mid-February – far ahead of the market’s pace in 2010.
“The market was probably getting ahead of itself, the secondary market was slightly rich, and pensions and institutional funds were focusing on a hot new issue calendar,” says Adrian Miller, fixed-income strategist at Miller Tabak Roberts Securities. “They slowed down their activity in stages when the volume of new issues went down, suddenly there wasn’t much value in secondary trading – and the economy worsened.”
Another factor was refinancings, which had contributed to the volume of new issues earlier in the year. “Investors started to think, Maybe companies are not going to be so quick to refinance from here on,” says Miller. “This hit low-quality names. But even pensions that typically trade higher credits with longer durations were placing money in some of these.”
That said, Miller expects investors to return later this year. “If the economy does gain traction,” he says, “that, coupled with low default rates, will start to feed interest in the high-yield market again.”
Miller figures spreads should narrow by 75 to 100 basis points by year-end “if the scenario unfolds as we expect. While many portfolio managers might have rotated their weightings out of higher beta, cyclical sectors into more defensive positions, in the third quarter we expect they will rotate back in to catch up.” High-yield could then look more attractive than equities, he adds, since high-yield debt often produces equity-like returns while corporate earnings growth is expected to remain “anemic.”
Some observers worry that more risk has been baked into the high-yield market since the big rally began in 2009. Specifically, some issuers were able to secure more advantageous – for them – bond covenants early this year than they had since before the crash. And while the Federal Reserve this week signaled its intention to keep rates low, concerns about the fate of a deficit reduction deal in the U.S., as well as the continuing Greek debt crisis in Europe and its potential spillover effects, still have many investors worried about interest rate swings. Inflation, followed by a shift to a tighter monetary policy by the Fed, could also dampen the market.
Miller, however, notes that default rates remain low and that the other, most visible threats are economic and not specific to the high-yield market itself. If the economy comes back and rates remain low, he expects, so will junk bonds.
