It’s Not 2007, and Junk Bonds Can Still Be Dancing
(Bloomberg) -- This year's Milken Institute conference, a Davos-like gathering of the world’s most eminent financial minds but in the sunny climes of Beverly Hills, has one consistent theme: valuations can't keep rising so the music must be about to stop. References to 2007 or even 1994 abound.
Sectors are getting disrupted, “but you’re not being paid for that risk’’ – Christian Stracke, Pimco global head of credit research
Behavior is getting closer to “what we were doing around 2007” – Fred Orlan, global head of fixed income, Jefferies
“We’re back to everybody buying everything without reading the documents” – A.J. Murphy, global head of capital markets, Bank of America
Choose your pick of potential flashpoints: rising U.S. interest rates, weakening loan covenants, or the boom in exchange traded funds. All are masking a lack of underlying liquidity. But the most prevalent villain of the peace is high yield. The extra yield sub-investment-grade companies pay more than government debt to issue bonds is widely seen as too low.
Asset managers are paid to worry. Still, there is no fundamental reason to suggest the end is suddenly nigh for junk bonds.
There are always deals which price too ambitiously – the 3.5 percent price drop in last week's high-yield deal for WeWork Companies Inc. is the latest example. But that does not mean the entire house is about to burn down.
Current economic conditions are pretty benign and inflation is under control in most major developed economies. Most important of all, unemployment is near record lows and the banking system is no longer occupied by zombies. And in the world’s largest economy, first-quarter corporate earnings are up 25 percent from a year earlier. There is clearly plenty of money sloshing around for sub-investment grade deals. T-Mobile US Inc. and Sprint Corp. have secured $38 billion in committed financing for their planned merger, which would turn them into the largest U.S. junk-bond borrower.
It’s easy to read too much into the changes happening in fixed income, and to get overly worried that the 10-year yield ticked above 3 percent. The repricing makes sense – President Donald Trump’s tax cuts need to be funded by a growing U.S. Treasury issuance schedule. And the Federal Reserve is not only raising rates but is now reducing its holdings of QE.
So as the safe haven appeal of government debt reduces while the overall quality of corporate credit improves, it’s logical for high-yield credit spreads to tighten. But the situation is hardly at an extreme – spreads have risen from their lows in January, which was the narrowest in four years.
While it’s true that rising interest rates are never welcome for the most-leveraged sectors, a decade of cheap money has allowed a broad swathe of companies to lock in fixed long-term funding at low rates. That will provide protection for years to come.
Which is why Moody's Investors Service says the global default rate for non-investment grade companies will decline to 1.81 percent by the end of this year, the lowest since April 2008. It helps that the most bankruptcy-prone borrowers, junk-rated oil companies, are being bailed out by higher crude prices.
The primary catalysts of the financial crisis – over-leverage in the housing and banking sectors – have been remedied. Equally, the upsurge in inflation that triggered the 1994 bond selloff is nowhere to be seen. A black swan might be flapping just over the horizon, but today, the credit markets are functioning as they should.
©2018 Bloomberg L.P.