By: Italia Almeida
2012 has begun with a strong uptick in investor interest in high yield bonds, and the launching of a smattering of bond strategy funds, including many aimed at capitalizing a seemingly risky market.
Despite the negative title, junk bonds are identical to standard bonds, except for the distinct credit class of the issuer. To be deemed a junk bond, the issuer generally has a low a credit rating, usually below a “B,” from Standard & Poor’s, Moody’s, or another other rating agency. The bonds offer higher returns because low-grade issuers have fewer options for acquisition of capital and must find a method by which to attract investors. However, higher returns do not come without increased levels of risk that these companies may default, leaving bondholders with nothing. The tradeoff in junk bonds is that they depend heavily on corporate stability.
One reason that junk bonds have become such a hot commodity is that the rate of corporate default has been lower than average since 2011, a fact that leads to higher investor interest in taking on the risk of investment in poorly rated corporations,. Corporate debt default rate has had a historical average of 4.59%, and is currently at 1.9%, down from 14.5% during the economic crisis of 2008. The outlook for low corporate default and perceived ability to pay the coupon rate has created a financial environment perfect for junk bond investment. This new environment has not been lost on many institutional investors who have started funds dedicated to capturing the interest in this market.
Another byproduct of the hot junk bond market is the new access to capital allows for increased numbers of leveraged buyouts of companies. Companies such as, Caesars Entertainment, HCA, and Energy Future Holdings, which had been dubbed by many investors as “the walking dead” due to a dearth of available credit for LBOs have smartly jumped on capitalizing the market readiness for risk. These companies have restructured their overburdened balance sheets and extend maturity dates on their current debt, and signing deals for billions in junk bond debt.
The image of strong junk bond market may invoke visceral negative reactions and memories of Michael Milken and the slew of LBOs in the 1980s, but the interest in the junk bond market could be good for a number of reasons. For one, it reinforces that investors are hungry for risk. The newfound confidence that corporations are healthy enough to pay coupon and not default seems to also signal that investor fears of a double dip recession have largely been quelled. Underlying this belief is that the mergers and acquisitions will be a growing a sector in 2012 and beyond.
The current inflated interest in the high yield market may also simply reflect a chasing of the high yield payoff involved in junk bonds, rather than a belief in potential growth of already overleveraged companies – an atmosphere driven by the policies enacted by the Federal Reserve. Currently the Fed, under Chairman Ben Bernanke, continues to keep interest rates at record lows, and has said to be committed to this rate through 2014, increasing the desire for higher yields. In fact, according to one portfolio manager, “central banks around the world have made holding any sort of riskless asset painful.” Investment grade bonds are also drying up as banks anticipate the implementation of regulations such as the Volcker rule, leaving the high yield options even juicier.
How long this cash flow to risky issuers will last remains to be seen, but already there are talks of overcrowding and the price of junk bonds already becoming artificially high. For now firms with strong capital market and bond expertise should see business continue to boom.