The junk-bond market registered the economic upturn early, provided the juiciest returns as easy money floated through world markets and has led the stock market step by step to its recent five-year highs.
So, what to make of the recent sharp decline in high-yield debt indexes from stupendously strong levels?
The Merrill Lynch U.S. High Yield benchmark has delivered a total return of almost 150% since it bottomed in late 2008, compressing the prevailing junk yield to below 6% and hoisting aloft the values of popular junk exchange-traded funds SPDR Barclays High Yield Bond (JNK) and iShares iBoxx High Yield Corporate Bond (HYG). Those ETFs have pulled back a quick 1% in price the last 10 days or so, a drop that the previously tightly linked stock indexes have so far ignored.
This should serve as one among several caution flags waving at investors as the stock market’s three-month rally matures. It would be unreasonable to suggest that after tagging along behind high yield’s relentless climb for four years, stocks could keep hiking uphill if speculative-grade bonds backslide much more, or for much longer.
Perhaps more relevant than what the setback in junk means for stocks, though, is what it could be saying about the prospects for high-yield debt itself in the current environment.
The 'coffin corner'
Make no mistake, with yields still near 6%, the junk market remains firmly priced, nearly defying the “high yield” label thanks to ultra-low base rates anchored by the Federal Reserve and powerful demand for income by retail and institutional investors. Financing conditions there are so easy they’re verging on promiscuous.
For a corporate issuer outside the top tier of creditworthiness, the market is beckoning them to sell paper, and they are complying; in 2012 new issuance was double the annual average of the prior 10 years.
Merrill Lynch strategists in recent days have drawn attention to the tenuous supply-demand balance in high yield by invoking the arresting aviation term the “coffin corner,” referring to “the altitude at which an aircraft becomes nearly impossible to keep in stable flight. It defines the situation, where the current speed is both the minimum required to maintain level flight and at the same time also the maximum speed at which air can travel over wings without losing lift.”
New issuance is strong, yet the secondary market for trading bonds is thin. Wall Street firms’ bond inventories are at generational lows due to some mix of stiffer capital requirements and meager opportunities for trading profits due to low market volatility. So the market's equilibrium depends on continued heavy inflows to high-yield funds, including those ETFs, which together are said to account for some 10% of junk-bond trading volume. The Merrill team points out that should Treasury yields rise much, there’s probably not enough of a cushion in yield spreads to prevent price declines on junk bonds.
Without raising too much alarm, this all seems to create a delicate situation -- a market that would not likely absorb any economic hiccup or localized financial accident without denting portfolios enough for investors to regret leaving them in the way.
Nothing nasty needs to happen, of course, should money keep finding its way into the market and corporate-default rates remain as minimal as they’ve been lately. For the typical investor, though, it’s worth looking into whether, at current valuations, high yield has become a victim of its own success.
In recent years, junk represented the best of both worlds, benefiting from easy liquidity, delivering a nice yield premium in an income-starved world and offering an “equity-like” bonus return thanks to their leverage to reviving economic conditions.
Now, though, with yields around 6%, high yield bonds look decidedly bond-like and fully priced. If the macro environment looks like it will support low rates to the horizon, it’ll mean the economy isn’t accelerating and bond fundamentals would stagnate or worse. If the world starts to boom, then 6% pretax yields will be sneezed at in favor of actual equities, just at a time when big buyout deals might hit the junk market.
Loomis Sayles & Co. bond sage Dan Fuss, with more than five decades in the business, last month told Bloomberg News: “High-yield is as overbought as I have ever seen it. This is absolutely, from a valuation point, ridiculous.”
The sweet spot of slow growth, low rates and no defaults could well persist and keep the high-yield market strong for a while. But anyone deciding to put new money to work there should expect to get back no more than the coupon at best, and be ready for some rough air along the way.