High-yield bonds: cut and dried

Dry January typically means no booze. This year it may mean virtually no yield. Shaking off worries about the Middle East’s instability and low grade trade wars, the interest rates offered on junk bonds are at historic lows. Analysts have warned for years of the consequences of a decade-long debt binge, stretched balance sheets, and fuzzy accounting. Yet companies continue to issue “high-yield” bonds with only medium coupons that investors seemingly have no choice but to scoop up.

The average coupon of new issue high-yield bonds in December was a skimpy 5.15 per cent, according to S&P LCD. That was the lowest it had recorded since it began tracking the metric in 2005. One example: American power producer Calpine, rated at a modest B grade, issued $1.4bn of bonds at a yield of just above 5.1 per cent at the end of the month.

The low yields result from a combination of declining benchmark rates — 10-year Treasury notes offer just 1.8 per cent — and investor capitulation on risk premiums. The ICE BofA high-yield spread index, representing the gap between payouts on speculative and investment-grade corporate bonds, has fallen to just 3.5 per cent, more than 100 basis points lower than a year ago. This collapse in spreads helped high-yield bonds return a juicy 14 per cent to investors in 2019.

With such enthusiasm for risk, companies are then happy to push the envelope. According to S&P, there were nearly 10 financings last year where the unadjusted leverage ratio was measured at greater than eight times total debt/ebitda. But those financings were marketed with forecasted, speculative cost savings to come. For optimists those savings brought the ratio down to 6.5 times.

Debt defaults are not off the radar. Industries like energy, retail and restaurants cannot shake off their troubles even if credit is practically being given away. The natural balance between risk and return will eventually reassert itself, but not soon. The Federal Reserve is too skittish to raise rates, removing the party punchbowl, while the economy keeps humming. Expect the mania to continue.

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