Global asset valuations are exuberant in anticipation of continuing robust recovery from the pandemic recession. To be sure, some optimism is warranted, but much of the potential future expansion may already be priced into current asset prices. Nowhere is this concern more evident than in the sector of the bond market that caters to lower quality, higher-risk borrowers. Investors seeking income in a low-yielding world have loaded up on high yield or "junk" bonds, taking on increasing risk in exchange for diminishing returns. With these risky bonds priced to perfection, investors should take note of the historic extremes and recognize that there is little room for error.
The yield on the average bond in the Bank of America ICE High Yield index fell to an all-time low of 3.9% last week, compared with 9.2% in the early months of the pandemic in 2020. Meanwhile, inflation has been picking up speed and registered a 5.4% year over year increase in June consumer prices. This produced another first: never before has the real (after-inflation) yield on junk bonds actually been negative. Just one more Covid era record.
Bonds come in a wide variety of flavors, with U.S. government issues generally considered the safest and stingiest. The U.S. 10-year Treasury bond currently yields a measly 1.2%. Bonds issued by corporations are graded according to their relative risk and financial stability, with AAA representing the cream of the crop. AA, A and BBB-rated companies are also considered "investment grade," appropriate for more conservative investors. While corporate bonds are somewhat riskier than U.S. Treasuries, investment grade bonds pay a small additional yield or "spread" over government bonds, typically 50 to 150 basis points (one basis point is 1/100 of one percent). Investment grade yields for intermediate maturities are in the 1.5% to 2.5% range.
High yield bonds fall below investment grade in quality and hence present greater risk. BB and below, also referred to as "junk" bonds, should offer significantly higher additional yield or "spread" to compensate for the greater risk of default by weaker companies. Examples include American Airlines and Carnival Cruise Lines, with bonds rated "B minus," reflecting significant default risk in the wake of Covid.
Faced with microscopic yields in investment-grade bonds, income-hungry investors have plowed into high yield. In 2020, a record $421 billion in new high yield debt was issued in the United States. This year, junk bond issuance is running 50% above last year's pace. As has happened in previous cycles, junk buyers are now undercompensated for their risk and are positioned to sustain losses when the inevitable turn in the cycle occurs. The current spread on the BofA High Yield index is less than 300 basis points (3%) over Treasuries. A year ago, it was 600 basis points (6%). With the spike in demand, weaker borrowers are issuing more debt at lower rates with fewer protections to buyers. Danger Will Robinson.
This song rhymes with the tune from 2005 leading up to the financial crisis. Current low default rates reflect a Goldilocks scenario for expanding output and profits. But with high yield spreads priced for a best-case result, risks are building.
There are signs that global growth may be slowing and could underperform forecasts. Inflation has surged over the past few months and while likely transitory, could convince the Fed to throttle back the monetary rocket engines. Markets are betting on a compromise infrastructure bill, but that outcome is hardly certain. Weaker companies are issuing more debt of poorer quality with fewer covenants, and investor recoveries on defaults are shrinking. And the more virulent Delta variant of Covid is preying on the significant unvaccinated population and further threatening the recovery.
The current high yield bond market is disregarding these risks for the moment. Default rates are expected to decline below 1% in 2021, similar to 2005. By 2007, the default rate reached 14% and junk bond investors got crushed.
Nothing like the financial crisis appears imminent, but a relatively small increase in credit spreads could create significant pain for investors when these risks are as undercompensated as they are now. Investors holding high yield bonds or bond funds should evaluate and calibrate their exposure accordingly.
Christopher A. Hopkins is a certified financial analyst ( CFA) in Chattanooga.