Yesterday, the average credit spreads among junk bonds have reached their lowest levels since the financial crisis.
Average Credit Spreads of U.S. Corp. HY Debt (source: Bloomberg and BAML):
Considering that U.S. Treasury yields are now lower than in 2007, when junk debt spreads were their tightest, junk debt yields are at their all-time lows.
Average Yields of U.S. Corp. HY Debt (source: Bloomberg and BAML):
Even yields of CCC-rated bonds (which carry a high risk of default) are trading at all-time low yields.
Average Yields of CCC-rated U.S. Corp. HY Debt (source: Bloomberg and BAML):
As such, we have taken a negative view on junk debt from a price perspective; the lower the rating, the less constructive our opinion. We continue to find value in BB-rated bonds from an income perspective as interest rates will probably remain relatively low for an extended period of time. However, we have taken steps to hedge some of our portfolios for a potential downturn in the high yield debt market should the Fed inject volatility into the markets. In that scenario, investors who overreached by investing (speculating is more accurate) in the depths of the junk debt market, might choose to move up the quality scale, only to find poor liquidity when they attempt to sell junk assets. We believe junk debt is in an overdone situation. (1)
As we were going to press, we saw an article on Bloomberg News discussing the securitization of bank loans into Collateralized Loan Obligations. Bloomberg’s Lisa Abramowicz writes:
“Here’s a brain twister: Some investors have grown tired of junk-rated loans, but others are more eager than ever to buy the same debt bundled together and sliced into pieces. Buyers are particularly hungry for the riskiest tiers of these collateralized loan obligations, investments that are the first to lose out if borrowers fail to make interest and principal payments. They also stand to reap bigger returns when companies pay back their loans.”
What caught our eye were the words “riskiest tiers.” These were the same glow-in-the-dark subordinate and super-subordinate tranches which ended up worthless (or nearly so) during the financial crisis. Bloomberg reports that while money has been flowing out of bank loans, money has been flowing into lower-tier tranches of securities collateralized by the same kind of loans. In other words, investors are selling their senior loan exposure to accept a junior claim on the same debt in order to pick up yield. (1)
We hope that investors and advisors know what they are doing. In 2007 and 2008, we saw allegedly AAA-quality CLOs and SIVs fail, with even the most senior tranches taking big hits to principal in most cases. Subordinate tranches were often left worthless. We would say that investors and advisors have short memories, but it is more likely that they are not even making a connection between now and 2007/2008. According to Moody’s, the U.S. high yield corporate default rate stands at 2.3% and is expected to decline to 2.1% by year-end. However, if anyone thinks that this is a new normal and that defaults won’t increase when the Fed is less accommodative, they are probably kidding themselves.
When we see investors scramble to take subordinate positions in already risky assets, we cannot help but to become concerned that junk debt is overvalued.
By Thomas Byrne – Director of Fixed Income – Investment ConsultantThomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. Employment
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY