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June Federal Open Market Committee impacts high-yield debt market

Phalguni Soni

Overview: The week in corporate bonds—the rate hike (Part 2 of 9)

(Continued from Part 1)

What are high-yield (HYG) or junk bonds (JNK)?

High-yield bonds (HYG) or junk bonds (JNK) are rated below investment-grade (for example—BB+ and below), as per the Standard & Poor’s ratings system. Credit ratings are an assessment made by ratings agencies like Standard & Poor’s and Moody’s that provide an opinion on the borrower’s ability to make timely payments of interest and principal. In general, higher ratings imply lower credit or default risk, while lower ratings imply the opposite. Due the higher risk entailed in high-yield debt, investors also require a higher return to compensate them for the risk.

Why the Fed’s monetary policy has investors flocking to the high-yield debt market

The Fed has followed an accommodative monetary policy since the fallout of the 2008 financial crisis and the Great Recession. This has been accomplished by quantitative easing and maintaining rates at unprecedented lows. As a result, investors with an appetite for higher risk and higher returns, have piled into high-yield (or HY) debt in search of higher yields.

This view was reinforced at the June Federal Open Market Committee (FOMC) meeting, despite the Fed announcing the expected $10 billion taper. “Even after today’s action takes effect, we will continue to expand our holdings of longer-term securities, and we will also continue to roll over maturing Treasury securities and reinvest principal payments from the FOMC’s holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These sizable and still-increasing holdings will continue to put downward pressure on longer-term interest rates, support mortgage markets, and make financial conditions more accommodative, helping to support job creation and a return of inflation to the Committee’s objective,” said Fed Chair, Janet Yellen at the press conference at the end of the June FOMC.

Impact of the economic recovery

The economic recovery, which is propelling the S&P 500 Index (SPY) to record after record high this month, is also a factor affecting yield spreads. Yield spreads between HY and investment-grade debt (BND) tend to narrow when the prevailing mood is of market optimism because HY issuers are believed to have improved prospects for servicing the debt.

Yield spreads for HY debt keep declining

In the present environment, with the economy on the road to recovery and the Fed still maintaining low rates, yields on HY debt have remained low and the yield spreads between investment-grade (or IG) debt and HY debt, have narrowed to multi-year lows this year.

These trends were in evidence last week as well in the HY debt market. High-yield debt yields (as represented by the Bank of America Merrill Lynch U.S. High-Yield Index) fell by four basis points over the week to 5.24% on June 13, 2014—their lowest level since May 9, 2013. The Option Adjusted Spread (as measured by the BofA Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread) (or OAS), also declined by six basis points to come in at 347 basis points—the lowest since July, 2007.

In the next section, we’ll analyze last week’s trends in the HY debt market as the well as the major HY debt issues, including those of DaVita Healthcare (DVA) and Tenet Healthcare Corp (THC).

Continue to Part 3

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