Why junk bond yields aren’t so absurd

The European Central Bank is worried about bad credit – it thinks there is too much gossip.

In his financial stability review, earlier this month, the bank wrote: “Signs of exuberance are increasingly visible in certain segments of the financial markets as real yields decline and the search for yield continues. Real yields fell to historic lows on indications of a slowing pace of economic recovery and heightened inflationary pressures, prompting risk-taking in financial markets. Issue activity in high yield corporate credit markets reached new highs in 2021. Despite large issue volumes, spreads remain at record levels, indicating a strong investor appetite for assets risky.

People are undoubtedly selling a lot of risky financial instruments, and others are paying very high prices for them, all over the world. This is not news. But the ECB is particularly concerned that investment funds and insurance companies, spurred by the collapse in real yields, have crammed into the risky end of the credit spectrum.

An ECB chart in its report showed increasing fund exposure to less liquid and lower credit quality assets. In particular, he demonstrated how insurance companies have dramatically increased their exposure to lower-grade, higher-grade bonds – bonds rated triple B, in the jargon. The chart also gives an estimate of duration risk, i.e. how much funds holding those assets will be affected if interest rates rise (as they might if inflation gets out of hand and banks control units must tighten the screws).

Meanwhile, in the United States, Bloomberg reported an increase in sales of riskier bonds: “Sales of US high yield bonds hit an annual record of $ 432.4 billion. [on November 16] as companies rush to lock in low coupons while they still can. Cheap financing costs triggered a prolonged build-up of debt issuance, and borrowers rushed to take advantage of the opportunity before the Federal Reserve finally raised interest rates. It could happen sooner than expected amid inflationary pressures. . . This dash lifted the 2021 issue beyond the 2020 $ 431.8 billion mark, which broke an earlier record set in 2012. ”

This wild demand for yield and a favorable economic environment designed by lax fiscal and monetary policy had a predictable effect on junk bonds. They have become very expensive and their yields are ridiculously low.

Spreads – the degree of additional return offered by riskier corporate bonds relative to sovereign debt – remain low.

European spreads have been at their pre-pandemic low for months; US spreads are even lower. It sounds crazy. Yes, corporate balance sheets and profits are both sparkling. But, of course, the bond markets should be looking to the future, and we can recognize that the party is drawing to a close.

The pandemic’s cascade of tax transfers to consumers is drying up, the U.S. government deficit will be lower next year, central banks are starting to cut quantitative easing, and a rate-tightening cycle is expected to begin in the middle of it. ‘year. So shouldn’t spreads increase?

Maybe not. Marty Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors – and a longtime observer of the high yield bond market – uses a five-factor econometric model of the fair value of high yield bonds. It takes into account economic activity, the availability of credit, default rates, Treasury yields (which generally move in the opposite direction of spreads) and quantitative easing. And, at the end of October, the model suggested that high yield bond spreads were 124 basis points below fair value, or about one standard deviation from normal.

“It’s fair to describe the market as expensive,” says Fridson, but not overwhelmingly. He dismisses the idea that the flood of emissions means yields must rise soon, arguing that historically, emissions meet demand, rather than the other way around.

The key factor in keeping fair value low in recent months, according to Fridson, has been greater availability of credit, which means companies have an easier time refinancing their debts and are less likely to default. Now, according to the Fed’s loan officer survey, the net number of banks tightening their lending standards has stopped falling, that is, the availability of credit has stopped increasing.

This can be a worrying sign. But there is another factor behind declining US spreads, which CreditSights’ Tomas Hirst identified: The quality of high yield bonds in bond indices has improved.

At the lowest level, triple C-rated and struggling companies have gone bankrupt or, more frequently, have repaired their balance sheets, meaning their returns have gone from around 10 percent to, say, 6 or 7. And it There has been a lot of issuance in the high-quality segment of the market: Double B-rated bonds, the highest echelon of the junk, now account for over half of the market, driving the returns again down. The index as a whole has become less risky.

So, the high yield market can be hot and expensive. But spreads are not very far from history or economic fundamentals.

If the ECB or any other central bank is looking for a savage pricing error that poses a risk to financial stability, then they might want to look not at corporate bonds, but at sovereign debt – the market in which they are. intervened directly.

About Mike Stevenson

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