EC Junk Jumpers – The Era Of Return-Free Risk

Crazy for Yield

A case of bad timing …

Cartoon by Eric Allie

In one of those markets definitely not distorted by central bank policy (see “Bernanke’s Apologia” if you’re wondering what that is about), an outbreak of craziness has just been spotted by CNBC. We are informed that investors are “jumping into junk bonds”:

“The supply of U.S. companies with junk-rated debt is rising just as investor demand for higher yields is climbing.

Moody’s reports a two-year high in company debt rated B3 negative or worse—a.k.a. junk—as part of a trend that has seen the list of 184 companies grow by 26 percent over the period. The rise has been led by oil and gas firms, which accounted for 12 of the 28 additions to the junk list in February.

What’s more, the roster would be even longer but for companies falling off the list due to reasons including filing for bankruptcy. Of the 18 issuers no longer rated, 39 percent filed either for bankruptcy protection or “distressed exchange, and 33 percent withdrew, with just 28 percent getting off the list due to upgrades. This is a reversal from the previous two quarters, when most companies left the list via ratings upgrades,” Moody’s said. “If this reversal continues, it could signal tough times ahead for speculative-grade issuers.” Not so far, though.

Fueled by low default rates and generally favorable credit conditions, investors in 2015 have been pouring money into funds that invest in high-yield debt. In fact, the previous six weeks before the most recent week had the highest level of flows to junk funds since the financial crisis in 2008 and 2009, according to Morningstar.

Flows to junk-focused funds have taken in a net $12.2 billion so far in 2015 as part of a broader interest in fixed income amid a turbulent stock market, Bank of America Merrill Lynch reported. In addition to the big cash attraction to junk, high-grade bond funds have seen net inflows of $36.4 billion.

(emphasis added)

The sentence about “companies falling off the list due to bankruptcy” is actually quite funny in this context. This sure hasn’t fazed the herd of greater fools just yet. We already discussed the fact that loan covenants have gone the way of dinosaurs in a previous post, but below is a reminder via the CNBC article. This in turn is enticing soaring issuance of junk debt:

In exchange for the alluring yields of junk bonds, which are currently about 6.1 percent on average, investors are sacrificing protection against defaults. Covenant quality, or the types of restrictions placed on issuers for financial practices after issuing the bonds, is at record low levels. Moody’s rates covenant quality on a scale of 1 to 5, with 1 being the most restrictive and 5 the least. In February, the average covenant score for all new bonds was 4.51, worse than the previous apex of 4.43 in November. The tolerance for weaker restrictions on practices such as taking on more debt or making risky investments represents an increase in faith that may not be justified when the bonds hit maturity.

Junk-grade companies are taking advantage. In a typical month, so-called high-yield lite junk bonds account for about 20 percent of total issuance of companies that Moody’s covers, according to Friedman. However, since September, the total has been closer to 40 percent, with February’s at a robust 46 percent during the same month when covenant weakness peaked.”