Wednesday, July 30, 2014

High Yield Corporate Junk - Inflating Another Asset Class

Updated September 2014

Actions taken by the Federal Reserve and their peers around the world have had a marked impact on interest rates, pushing them down and keeping them at ultra-low levels for an extended and unprecedented period of time.  This has created a demand for yield and has pushed many investors into fixed income investments that they would otherwise not consider given the risks involved.  This is particularly true for what is termed "high yield corporate debt" aka "junk bonds".

Every quarter, Thomson Reuters releases its "Debt Capital Markets Review" which looks at the world's debt markets, including the market for "junk".  In the first half of 2014, global debt capital markets' activity totalled $3.2 trillion, an increase of 4 percent on a year-over-year basis and the strongest since months in global debt capital markets since 2009.  In the second quarter of 2014, the volume of high yield corporate debt issued reached a new quarterly record of $148.3 billion, up 14 percent from the previous quarterly record seen in Q1 2013.  Of the high yield debt issued in the first half of 2014, 63 percent or $260.5 billion went to issuers in the United States, France and the United Kingdom, up 9 percent over the same period in 2013.  In the United States, over the first half of 2014, a total of $176.47 billion worth of high yield corporate debt was issued in 296 separate deals, up 2.1 percent on a year-over-year basis.  Europe saw their high yield issuance rise by 47.4 percent over the same period in 2013 to $107.5 billion.

Here is a graph showing the increase in the issuance of global high yield corporate debt:

You'll note that the issuance of junk debt over the past year (Q2 and Q3 of 2013 and Q1 and Q2 of 2014) is far higher than in any other four quarter period going back to the beginning of 2006.  That can be attributed to two factors:

1.) With interest rates at or near all-time lows, less creditworthy corporations are trying to raise money while it is inexpensive to do so.

2.) With interest rates at or near all-time lows, investors are desperate for yield and are choosing to ignore the risks involved in junk bonds, pushing up bond prices and pushing down yields.

As we all know, there is a lot of money to be made underwriting corporate debt deals.  Let's look at the biggest beneficiaries of the global debt issuance:

You'll observe that the list is a who's who of Wall Street that lined up to benefit from American taxpayers' "involuntary generosity" during and after the Great Recession.  

In total, the top ten bookrunners issued $1.979 trillion in global debt and equity and raked in a cool $12.174 billion in manager fees in the first half of 2014.  Underwriting fees for high yield debt over the same period totalled $3.4 billion, up one percent from 2013 and made up 28 percent of total fees earned.

Lastly, let's look at the spread between the benchmark yield (i.e. the no-risk yield) and the yield on junk bonds:

The spread between no-risk fixed income investments and high yield debt is now at a five year low of less than 3 percent, less than half its normal level, largely because of the massive investor demand for yield that has resulted in higher prices/lower yields for junk bonds.  This demand has resulted in several high yield deals of unprecedented size in the first half of 2014 including the largest ever by Altice and Numericable's $16.5 billion deal to fund their purchase of SFR, the French mobile company.

The spectre of a looming high yield corporate debt collapse is real.  As interest rates on high grade debt rise, the prices of high yield bonds will drop, leaving investors with a potentially substantial capital loss.  As well, as interest rates rise, the less creditworthy companies that were able to issue debt during this low interest rate period will find it difficult to raise additional debt, particularly if investors see the debt as risky.  This will make it difficult for these corporations to expand their operations.

Thanks to the Federal Reserve's monetary experiment, we have seen interest rates compressed to an artificially low level, resulting in fixed income investors taking risks that they may otherwise have been unwilling to take.  Given the bloating of the junk bond market over the past two years, the bursting of the corporate high yield debt market will be particularly painful for many investors.  On the upside, Wall Street will still get to keep the billions of dollars in fees charged to help investors invest!

1 comment:

  1. Money has become so cheap to borrow that many people are now arguing that you must take it even if you don't know what to do with it. It is hard to imagine how much this is distorting the economy, markets, and reality in general. A total disconnect between life on main street and the financial world is occurring and it is putting the economy in a very dangerous place.

    It is often hard to determine what is true, but a report on Bloomberg that 32 Trillion dollars in funds were held in offshore accounts around the world made me shutter. How safe is this money, and what exactly is it doing? Can you say Cyprus? More on this subject in the article below.