Weakest U.S. Junk Bonds Shine as Investors Clamor for Yield

(Bloomberg) -- Bond investors can’t get enough of the weakest corporate borrowers.

The riskiest U.S. junk bonds have already gained 1.6 percent this year through Thursday, far outstripping returns for the safest high-yield debt, and their prices are by one measure the highest in 40 months. Tax law changes have made investors more hopeful about corporate profits and broader economic growth, fueling gains in stocks and speculative-grade bonds. Surging oil prices have helped too.

Exuberant investors on Thursday piled into notes from Arby’s Restaurant Group Inc., a fast food company whose bonds are rated CCC+, one of the weakest junk grades. The company is paying paid 6.75 percent annual interest on the eight year notes -- about 1 percentage point less than the average for similarly rated corporate bonds maturing around the same time, according to data compiled by Bloomberg.

Last week Ardagh Group SA, an Irish packaging company, sold bonds that allow it to defer interest payments, the first “pay-in-kind” notes of the year. The structure is particularly risky because Ardagh already has PIK notes outstanding, and it borrowed through a new holding company, which is the last to receive cash flow from its operating businesses.

“It’s Tempting”

“It’s tempting to reach for yield now,” said Henry Peabody, a money manager at Eaton Vance Corp., which oversees more than $400 billion of assets. “But markets have a way of punishing people who reach for yield for too long." Eaton Vance is staying away from the lowest-rated speculative-grade bonds, he added.

For now, many investors are giving in to temptation. The gap between yields on the worst junk bonds and the safest is at its narrowest level since 2014. The riskiest bonds, those rated CCC, are yielding more than 8.1 percent through Thursday, according to Bloomberg Barclays index data, close to their lowest level since September 2014. The gains for CCC rated corporate bonds this year are more than twice the 0.66 percent increase for high yield corporate debt as a whole.

A spokesman for Ardagh declined to comment beyond the company’s prior statements. A representative for Arby’s was not immediately available for comment.

Buying Selectively

There are more of these bonds to choose from after ratings downgrades have exceeded upgrades since 2012 for junk borrowers, according to Bloomberg data based on Moody’s Investors Service ratings. Bonds in the category of CCC make up 13.7 percent of the Bloomberg Barclays High-Yield corporate index, up from 12.9 percent two years ago.

Investors may be able to boost their returns by selectively buying CCC rated debt from energy companies, Wells Fargo & Co. strategists wrote in a report last week. As the price of oil jumped last year, the companies have seen their ratings upgraded and found buyers for their bonds, giving investors some confidence that the companies can refinance debt when they have to.

Risk On

With the stock market up by more than 4 percent so far this year, investors are more willing to take risk, said Mike Collins, senior investment officer at PGIM Fixed Income. And higher yields help insulate investors against the risk of the Federal Reserve hiking much more from here, he said.

“Whenever you have a risk-on market environment and high yield is doing really well, it’s almost always the case that the lowest-rated highest-yielding bonds do the best,” Collins said. He has been selling higher rated speculative-grade corporate bonds and looking for opportunities in those rated CCC.

There are big headwinds ahead for CCC rated corporate bonds too, the Wells Fargo strategists led by George Bory wrote. As the Federal Reserve raises rates and central banks globally move closer to shrinking the money supply, the lowest-rated bonds could get hit hardest. Tax reform could help companies in general, but may give the least benefit to companies with the most debt, the strategists wrote. In areas like communications, consumer discretionary and health care, investors should be more cautious, they said. 

Companies with CCC ratings tend to be shaky. In 2017, about 6 percent of borrowers rated Caa1 or below defaulted, according to Moody’s Investors Service, compared with 3.3 percent for junk debtors overall. The companies tended to generate less than half the earnings necessary to cover their debt, Moody’s data show, compared with around 3.7 times for those with the highest junk ratings and 6.4 times for borrowers at the lowest investment-grade levels.

‘Gravy Train’

By one measure, valuations on CCC rated notes are reasonable, according to Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC. When high-yield spreads are narrower than usual, the gap between CCC spreads and BB spreads tends to be tighter. Based on historical measures, BB and CCC spreads should be closer together than they are, he wrote in a Jan. 9 report published by S&P Global Market Intelligence. But if the broader market weakens, the riskiest securities will get hit hardest, he added.

One struggle for investors looking for higher yielding bonds is finding willing sellers. Wall Street banks have kept low inventories of the debt since the financial crisis, and investors that have higher yielding debt don’t want to let go of it, said Eaton Vance’s Peabody.

“It doesn’t seem like many are willing to get off the gravy train,” Peabody said. “We’re at that stage when people want to wait for an event or risk to pop up to switch positioning, but that can be a dangerous position to hold for too long.”

©2018 Bloomberg L.P.

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