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Why did junk bond issuance reach new heights last week? And why has it nearly reached an annual record high this year?
While yield-hungry investors are probably looking for anything they can get, it seems a few things have happened this year for the stars to have aligned so neatly for junk.
Most obviously, there is currently a broader rally into corporate bonds generally, and junk bonds are along for the ride.
But another reason is that junk issues have turned out to be less rubbish than expected, at least for now.
In March we posted this chart, spotted by Jim Fickett over in the Long Room:
As Fickett noted:
The fraction of CCC or lower-rated bonds approximately doubled from early 2007 to early 2009. And according to a recent report from Fitch, the fraction at the end of 2009 was still 27%.
The report also stated that spreads should be lower than their historical average, and that the “default situation could turn ugly again if economic and market conditions slip back into recession or into a positive but anemic growth environment.”
And indeed, junk bond issuance declined in May and June as fears of a eurozone debt crisis escalated, according to Dealogic numbers cited by the FT. But the rally then continued in July, despite the worsening US economic outlook.
In a broad overview of the asset class a few weeks ago, Heidi Moore explained one reason why (emphasis ours):
In 2010, companies that issue high-yield bonds are defaulting on that debt at a rate of only around 1%, compared with more like 14% in 2009, according to a new report from Fitch Ratings credit analyst Mariarosa Verde. Verde notes that there are both fewer and smaller companies defaulting on their high-yield debt in 2010. For a bit of context, the current default rate on junk bonds compares to a historical default rate between 4% and 68%, depending on the junk bond’s rating. Now junk bond defaults are so low that they are half the historical default rate for highly rated — or investment-grade — corporate debt, a which historically maintained a 2% default rate. Municipal bonds issued by the most financially sound cities and states historically default by 0.7%. So right now, junk bonds are about as likely to default as highly rated munis.
Heidi also notes that a number of the potential defaulters identified during the crisis did indeed default before the year began, and the asset class may have been due for a rally after plummeting during the recession.
Then again, this year’s rally is also a supply-driven story, as private equity firms are capitalising on low yields to refinance the debt in portfolio companies, perpetuating it further. From the FT:
Private equity sponsors have been trying to chip away at what has become known as the maturity cliff, or wall of debt that matures starting in 2012. Junk bond sales to repay loans from the buy-out era are coming at a record pace in August, according to Standard & Poor's Leveraged Commentary & Data. S&P reported nearly $6bn of such activity in the first 11 days of the month.
So, plenty of factors combined to support the surge in issuance. As for whether this can continue, well, these are strange times, with markets exhibiting all kinds of peculiarities, so we suppose anything can happen.
But analysts were mixed on whether this remains an attractive asset class for investors, and one obvious problem is that all the recent issuance might take some time for the market to absorb. As Bloomberg notes, yields on junk bonds climbed at the end of last week, as did spreads against government debt. The asset class may be due for a pullback, and there’s nothing to say that the same problems it had in May and June can’t reappear.
For our part — we’ll just agree with Aleph Blog and say that caution seems appropriate.
Related links: Sales of junk bonds set to reach new high – FT Investors really â?¥ junk. We mean really. – FT Alphaville Junk bonds: now with less junk – Street Sweep
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