Thursday, December 10, 2015

Corporate Junk - Preparing for the Inevitable

There is one issue that the Federal Reserve's protracted period of near-zero interest rates have created that doesn't receive a great deal of coverage in the mainstream media.  This issue could prove to be a significant problem for millions of hapless small investors who have been doing their best to get a reasonable return on their meagre savings.  Please note that I will be using the terms "high yield debt" and "junk bonds" interchangeably throughout this posting.

Here is a graph from Thomson Reuters' Debt Capital Markets Review for the first nine months of 2015 showing the volume of high yield corporate debt (i.e. junk bonds) that have been issued globally every quarter since 2007:

You can easily seen how the volume of junk bonds has grown since the end of the Great Recession as interest rates have fallen and remained at generational lows.  Global high yield debt volumes decreased 19.8 percent in the first three quarters of 2015 compared to the previous year, however, a total of $297.3 billion of junk debt was still issued over the nine months.  Yields rose from 6.4 percent in Q2 2015 to 6.8 percent in Q3 2015 with an annual average of 6.3 percent for all of 2015 so far, still hardly reflecting the risks involved.

There have been two main factors at work in the global junk bond market over the past six years:

1.) Less creditworthy companies wanted to issue debt at ultra-low interest rates that simply didn't reflect the risks involved because they could raise a lot of cash without paying a lot of interest.

2.) Debt markets/investors demanded a reasonable return on their investment dollars and since interest rates on Treasuries, other government bonds and creditworthy corporations were unreasonably low, the demand for higher yielding junk bonds grew significantly.

This graphic shows the issue type composition for the world's top global debt bookrunners (i.e. underwriter for the bonds being issued) for the period between January 1, 2015 and September 30, 2015 with junk bonds being coloured turquoise:

For every underwriting bank with the exception of Morgan Stanley and Credit Suisse, more than 14 percent of their total bonds issued over the 9 month period consisted of junk bonds with Wells Fargo having the highest proportion of junk bonds at 19 percent of their total underwriting over the period.

Let's take a look at the issuance of high yield debt in the United States for the first 9 months of 2015 as shown on this table:

In total, in the first 9 months of the year, Wall Street banks have issued $216.499 billion in high yield corporate debt, down 11.8 percent from the same period in 2014.  These dubious investments have earned the top ten issuers $2.105 billion in underwriting fees, down 14.5 percent from the previous year.  JP Morgan is, once again, the largest book runner with 142 deals for 46.1 percent of the market share on deals with proceeds of $24.518 billion.  For their troubles, JPM has earned $333.9 million in fees.  You can see why Wall Street loves a sucker!

Now that we have that background, let's look at what has happened to all of this "junk" that has been floating around.  Keep in mind that bond yields act inversely to price; as the price of a bond drops (i.e. because it is seen as a risky investment), yields will rise and vice versa.  As well, the spread between a bond that is deemed a "zero risk investment" like a Treasury and a junk bond  (CCC-rated in blue) will normally be higher than between a Treasury and an investment grade corporate bond (AAA-rated in red) as you can see on this graph:

Here's what has happened to the yield on CCC-rated/junk bonds since the end of the Great Recession:

The yield on junk bonds fell to a post-Great Recession low of 7.9 percent in June 2014.  Since then, it has risen to 16.73 percent, finally reflecting the risk involved in many of these bonds that Wall Street has made billions of dollars in commissions selling to unwary investors.

As I noted above, bond yields and prices act inversely to each other.  As such, here is a chart showing what has happened to Barclay's High Yield Bond ETF over the past year:

JNK is now at its lowest level over the past year.  If we look back further in time, here's what has happened to JNK since December 2007:

Not only is JNK at its lowest level over the past twelve months, it is now at its lowest level since July 2009.  This would suggest that many investors have seen the value of their high yield bond holdings decline substantially in value as the market is awakening to the fact that many of these bonds, particularly those issued by the beleaguered commodity sector, (i.e. oil) are starting to reflect their true risk profile.  If you want some idea of how big this problem could be, here is a graphic showing the historical volume (in billions of dollars) of B, BB and CCC-rated debt is in the United States:

Estimates by UBS suggest that 35 to 40 percent of the American high yield debt is "at risk", working out to roughly $1.05 trillion to $1.2 trillion in low quality speculative grade debt that will be difficult to refinance.

Thanks to the Federal Reserve and its braintrust, American investors (and others around the world) are likely to feel a great deal of pain over the coming months as the global economy looks set to slow down and the corporate world finds itself unable to service its mounting debt levels.

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