The junk bond market is on hearth this 12 months as yields hit document lows

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, USA on July 13, 2021.

Brendan McDermid | Reuters

Junk bonds are no longer so junky, with a strong fundamental background that helps underpin one of the traditionally riskiest areas of financial markets.

Yields in the range of $ 10.6 trillion on the lowest quality bonds are at all-time lows after a tumultuous year of American companies facing the Covid-19 pandemic and coming out with exceptionally strong balance sheets.

Bond yields fall as prices rise; the two have an inverse relationship to each other.

Most recently, the junk bond sector returned a total of 3.97% according to the ICE Bank of America High Yield Index. That is a record low of 3.89% on Monday.

In March 2020, during the worst volatility of the pandemic, the return was 9.2%. This marks the first time in history that the collective rate of return on scrap has fallen below the rate of inflation, as measured by the consumer price index, which rose 5.4% yoy in June.

At the same time, the spreads, or the difference between high-yield bonds and Treasuries of similar duration, fell to 3.05%, just below the lowest level since June 2007.

Falling junk bond yields aren’t a problem – yet

While the prospect that the worst-rated companies can pay less than 4% to issue bonds could raise the specter of an emerging bubble, most bond professionals don’t see any major problems, at least not yet.

“Companies weathered the storm last year and have positioned themselves really well,” said Collin Martin, Fixed Income Strategist at Charles Schwab. “Combined with return-hungry investors who invest in anything that offers a return greater than 0%, it really is the perfect storm when spreads fall to pre-financial crisis levels.”

Corporations have accumulated huge amounts of cash in recent years, with non-financial corporations totaling $ 6.4 trillion in cash by the first quarter of 2021, according to the Federal Reserve. That has increased by almost 50% since 2018.

They built money by taking advantage of interest rates that the Fed kept at record lows, a situation that has proven particularly beneficial for lower quality companies.

Increasing emissions, overwhelming returns

High yield bond issuance totaled $ 298.7 billion in 2021, up 51.1% from the same point in time in 2020, a year when SIFMA data showed a record breaking US $ 421.4 billion Dollars were spent on junk emissions. At the same time, investment grade emissions plummeted 32.7% this year.

The returns weren’t exactly great for investors. The $ 9.3 billion SPDR Bloomberg Barclays High Yield Bond ETF is barely positive for the year but has a yield of 4.21%.

While investors have shunned ETFs that trade in the high yield market – the aforementioned JNK ETF actually recorded outflows of $ 3.34 billion in 2021 – mutual funds and institutional investors were willing to take the risk for some return .

“It’s a tough world for investors because valuations are terrible, but fundamentals are pretty good. Fundamentals usually win,” said Tom Graff, Brown Advisory’s head of fixed income. “We’re pretty wary of high-yield bonds. We own a few. This risk / reward ratio is so skewed right now, but you have to be realistic. It probably won’t go the other way anytime soon.”

Like others who talked about junk, Graff said investors can protect themselves by climbing the quality ladder – single or double B companies instead of the riskier C ratings.

Fallen angels vs. rising stars

Part of that story is an interesting reversal of momentum for the broader bond market.

One of the major concerns over the past two years has been the increase in companies that bond professionals refer to as “fallen angels” or investment grade companies that have slipped down the ladder. That narrative has changed, however, as investors are now looking for “newcomers” or companies whose credit quality is improving.

Companies that were once investment grade and became speculative have improved the overall profile of the lower valued parts of the market and could move higher themselves as their balance sheets improve.

Some examples of companies climbing the ladder this year include First Energy, Murphy Oil, and Booz Allen Hamilton, according to Moody’s Investor Service. Those heading towards the Fallen Angel include Darden Restaurants, Delta Air Lines, and General Motors.

“With all of the downgrades over the past year, market credit quality is higher than ever,” said Bill Ahmuty, head of the SPDR Fixed Income Group at State Street Global Advisors. “This is helping to drive total returns down and making spreads a little lower.”

Wall Street predicts that the level of companies climbing the quality bar will increase significantly by 2022 after small changes in a 2020 market that saw near-record numbers of Fallen Angels.

Citing Barclays data, Ahmuty said rising stars will have four or five times as much debt as fallen angels by 2022. At the same time, it is forecast that default rates will be well below the historical average.

“High yield indices have a higher credit quality. You have lower predicted failure rates and you have that component where you will see rising stars for years to come, ”he said. “There is a good basic backdrop.”

The negative effects of inflation

One element that could spoil the high yield party is inflation.

The almost 13-year high in the consumer price index in June is another signal that inflationary pressures are sustaining and that there is a longer-term risk of driving interest rates higher. As yields and prices move in opposite directions, higher bond yields would erode the rise in capital prices of bondholders and especially harm fund owners.

The Federal Reserve has vowed to stay on the sidelines until its employment targets are met, but the danger of a tighter central bank always looms above the bond market.

“What kills a credit rally is the tightening of the Fed. More restrictive rhetoric from the Fed than expected can also undo a credit rally,” said Martin, the Schwab strategist. “We have seen very high spikes in inflation and signs of more hikes than expected from the Fed. But the markets are just shrugging.”

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