Bond Investors Take Ever-Riskier Bets in Hunt for Returns
(Bloomberg) -- Bond investors, emboldened by a recovering economy and a global vaccine rollout, are taking on more risk, sometimes a lot more risk.
Insurers, pension systems and high-grade credit managers in the U.S. and Europe are buying bigger amounts of junk-rated debt to offset shrinking yields, forcing high-yield investors to jostle for allocations of BB rated bonds -- the safest and largest part of their class with 60% of the market. Some fund managers, used to having their pick of speculative-grade bonds, have seen their orders for new bonds cut in recent months, they said, declining to be identified because the information is private. One high-yield fund manager said his orders have been scaled back by as much as 15%.
The soaring demand has reduced yields to record lows, pushing investors into the chancier subordinated parts of a company’s capital structure. It’s a bonanza for companies seeking to raise cash, with borrowing costs dropping and even the highest risk ones able to get a loan and sometimes increase the size of their sale.
“The market’s running hot, and that’s forcing investors to look more broadly at opportunities because of how tight things have been squeezed to,” said John Cortese, co-head of U.S. credit trading at Barclays Plc in New York. “The traditional high-yield investor that’s wanted to get paid 5%-7% yield is looking at higher-yielding parts of credit markets,” like CCC rated bonds, private credit and even collateralized loan obligations, bundles of junk debt packaged into chunks of varying risk and return.
Investors have been piling into speculative debt to wager on what they expect to be a roaring global economy in the second half of 2021 as more people are vaccinated. U.S. gross domestic product is projected to rise 6.1% this year, according to the latest Bloomberg monthly survey of economists. That would be the largest growth rate since 1984. Covid-19 death forecasts and other pandemic indicators have improved in recent weeks, although variants and a slower vaccine roll-out in the European Union are complicating the picture.
This optimism has driven down U.S. junk-bond yields. Average yields for dollar-denominated CCC rated bonds, the last credit rating before default, stood at 6.1% on Friday, the lowest on record. In Europe, CCC yields are touching 5.8%, the lowest since 2017, and down from a whopping 19% at the height of the pandemic last year.
“The issue with high-yield in general is the valuations are still quite stretched on a historical basis,” said Matt Brill, head of North America investment-grade at Invesco Ltd., a $1.4 trillion asset manager. “You think you’re getting a really interesting, attractive opportunity, and it still only yields 3.5% to 4.5%.” Contrary to his usual strategy, Brill says he’s been dipping into BB junk bonds with funds typically used for high-grade debt.
As a result, traditional high-yield investors have had to search even harder for investment opportunities. Mark Benbow, a high-yield fund manager at Aegon Asset Management in the U.K., said he has been shifting out of BB credit since the middle of last year.
“Our strategy at the moment is going bigger on short-dated high coupon debt and for this we’re having to look at riskier names,” Benbow said. Only 24% of his fund currently is in BB rated debt, down from as much as 60% in 2017, and he has increased its exposure to CCC credit.
Some investors worry that junk bonds are priced to perfection. Right now, central banks are supporting financial markets with low rates and easy monetary policy. The European Central Bank on Thursday said it’s stepping up its emergency bond-buying program, another support for economic recovery. But rising government bond yields, triggered by an uptick in inflation forecasts, means that sentiment could turn quickly. For those who loaded up on riskier debt, the scope for losses is much bigger.
“With spreads and yields as tight as they are and such a lack of dispersion in the market right now, there’s very little upside, but plenty of downside if things don’t go to plan,” said Jeff Mueller, the London-based co-director of high-yield bonds at Eaton Vance, who helps manage $486 billion in assets.
Bank of America preached caution in a note to clients last week, saying that corporate bond buying by investors seeking to benefit from the post-pandemic recovery has made some parts of the market look “eye-wateringly stretched.”
Still, the buying pressure for riskier debt has been relentless, helped by a surge into junk bonds by pension funds and insurance companies, typically more conservative investors. These institutions are increasing their orders of BB rated bonds by as much as 30% compared to last year, according to a person familiar with the matter.
Regulatory filings show insurance companies, including Manulife Financial Corp. and Allstate Corp., are among the largest holders of Carvana Co.’s CCC rated bonds issued last fall. Carvana, a used-car retailer, has never posted a quarterly profit. In Europe, insurance funds have been buying significantly larger portions of new issue junk bond deals than they did last year.
The borrowers benefiting from this hunger for yield are a Who’s Who of companies with problems.
German beauty retailer Douglas GmbH recently raised a 2.4 billion-euro refinancing, with investors overlooking falling sales and shuttered stores. A Douglas representative didn’t respond to an email and voicemail seeking comment.
In the U.S., CEC Entertainment Inc., the parent of Chuck E. Cheese, issued $650 million of junk bonds in April, less than four months after it exited bankruptcy. Moody’s Investors Service assigned the bonds a Caa1 rating, putting them in the riskiest tier, and noted CEC’s “very high debt leverage and weak same store sales trends.”
Investors were undetered, placing so many orders for bonds that CEC increased the sale’s size and cut the interest payment, to 6.75%.
The betting is that a downturn is still years away. “We’re probably two to three years out before we start seeing a traditional default cycle play out,” Ares Management Corp. Chief Executive Officer Michael Arougheti said at a virtual Bloomberg News event earlier this month.
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