Beware the junk bond boom

How well have junk bonds performed? In the last year, junk bonds - or high-yield bonds as they are often called - have done brilliantly. They returned about 32% globally, according to Lehman Brothers, their second-best annual performance ever, trailing only 1991’s record 46% return. European junk bonds returned 26%, easily eclipsing the stock-market, gilts and investment grade corporate bonds.

It was a remarkable rebound from the lows reached in 2002, when many investors wouldn’t touch high-yield bonds with a bargepole. At that time, corporate scandals, such as those at Enron, WorldCom and Tyco, triggered a wholesale loss of confidence in corporate balance sheets. Many bonds were selling for only a fraction of their face value and yields were often in the teens. Today, the average US junk bond sells for 102% of its face value and yields 8.42%.

Junk bonds: what is driving this rally?

Ultra-low interest rates. The US Federal Reserve last year cut interest rates to 1%, their lowest level in 45 years, triggering a US economic recovery. As companies started to repair their balance sheets with low-cost debt, investors regained confidence in the market. When Nalco, an unprofitable firm, wanted to issue bonds in November, for example, it was able to do so at 9% - “a yield that could not have been matched by a company with a top-notch junk rating in 2002”, notes The Economist. Yet the issue was more than four times oversubscribed, so Nalco took advantage and raised another $450m in January. Moreover, the easy availability of credit has fuelled competition between banks, leading to easier terms for borrowers.

Junk bonds: is this a bubble?

Not necessarily. But some analysts do think the US junk-bond market is now “priced for perfection”. At the bottom of the market in 2002, junk bonds on average yielded 10.97% more than US government bonds (this is the “spread”). Today, the spread is under 5%. Martin Fridson, publisher of Leverage World, a research service focusing on junk bonds, calculates that, at current spreads, the market is overvalued and yields need to fall by 1.77% to reflect prevailing risks. With yield differentials between low and high-risk bonds now so narrow, many experts feel junk can go no higher. If yields were to rise just 0.5%, one bond fund manager told Barron’s, the resulting price decline would offset the extra income from holding high-risk bonds.

Junk bonds: why are prices so high?

Investors have been encouraged by evidence that junk bonds have become less risky. There has been a sharp fall in default rates to 5% of outstanding bonds over the past 12 months, compared with a peak of 23% in November 2002, and as the corporate recovery gathers pace, default rates should fall further. Moody’s predicts the rate of corporate defaults will fall to 3.4% by January 2005. Another factor underpinning these valuations is the surge in the stockmarket, which has reduced companies debts as a proportion of total enterprise value.

Junk bonds: what could spook the market?

The biggest fear is a repeat of 1994, when the Federal Reserve raised interest rates for the first time in 16 months, triggering a sell-off in the bond markets. Then, as now, the US was growing without producing jobs and had a big trade deficit. Some investors fear the Fed is once again poised to start raising rates. At its last meeting, it changed its wording on the future direction of rates, saying not that they would be on hold “for a considerable period”, but that the Fed would be “patient”. Indeed, Alan Greenspan, the Fed chairman, appeared to be warning bond investors their capital was at risk in his bi-annual report to Congress, when he noted that if the Federal government continued to run massive budget deficits, it could trigger “an appreciable back-up in long-term interest rates”.

Junk bonds: is a significant sell-off likely?

Although most analysts expect inflation and interest rates to rise in the coming year, few expect a repeat of 1994, when US interest rates rose from 3.25% to 6% in 12 months. The consensus is for a gradual increase in rates around the world in the year ahead. One big concern, however, is the role of so-called “hot money” in the market.  Nobody knows for certain how far large flows of short-term speculative money were responsible for driving the surge in the junk-bond market last year, but it is estimated that there are at least a couple of billion dollars of this kind of cash in the market. Much of this will have come from market-timers - hedge funds that buy into junk bonds, hoping to capitalise on short-term moves. When this money is withdrawn, one fund manager told Barron’s, “there is going to be this huge sucking sound”.

Junk bonds: are there better options in the bond market?

Many of the concerns expressed about the US junk-bond market also apply to other high-risk bonds, not least emerging-market bonds. Like junk bonds, emerging-market bond markets have soared in the last year. Brazilian bonds, for example, have returned a staggering 124% since October 2002 and spreads over US Treasuries have fallen from 23% to just 4%. Other countries with tight spreads include Ukraine, Ecuador and Venezuela, none of which are bywords for stability. Nor are investors likely to fare much better with high-quality investment grade corporate and government bonds, since these are most sensitive to interest-rate hikes. The consensus is that inflation will stay low and rates will rise  slowly, but if that is not the case and rates move up fast, the bond markets will suffer.