Junk Bond Rally Obscures a Gathering Storm
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The slump in sub-investment grade debt at the end of 2018 is a more accurate portent of the market than the rally since then, investors say.
Most of the 500 financial professionals who gathered this month at a hotel in Mayfair, London’s billionaire neighborhood, for a conference on debt markets organized by Citigroup Inc., are bracing for a storm.
In a show of hands, around 80 percent said they view the junk-bond slump at the end of 2018 that wiped billions from portfolios as “the shape of things to come” rather than “merely a bad dream,” according to a summary of the event by Citi.
Across town at the same time in the brutalist Barbican complex on the northern edge of London’s financial district, Bank of England Governor Mark Carney was giving a speech on the global economy. The booming market for lending to high-risk companies was evoking memories of the subprime crisis a decade ago, he said.
The chorus of warnings is getting louder from policy makers and industry insiders. They argue that risky companies have too much debt on their books, leaving them vulnerable to shocks such as higher borrowing costs.
Carney’s speech followed remarks from sources as diverse as U.S. Senator Elizabeth Warren and the Bank for International Settlements. The Federal Reserve revealed in minutes of the Federal Open Market Committee’s September meeting that some officials said the growth of leveraged loans and looser standards present “possible risks to financial stability.’’
“Some might argue they are ‘crying wolf’ but if we end up in a liquidity crisis, nobody can say they have not been warned,” said Jorgen Kjaersgaard, head of European credit at AllianceBernstein. Policy makers are upping the rhetoric because they are unwilling to apply the brakes with tighter monetary policy, so they “communicate about the dangers instead,” Kjaersgaard said.
The total of leveraged loans and high-yield bonds outstanding in Europe and the U.S. has doubled to about $2.65 trillion since the financial crisis, according to the BIS, known as the central bank for central banks.
“The idea that the market is over-levered is true, but the fact is, fund managers have to invest the money we’re given, so it means choosing between the lesser of evils,” said Rajat Mittal, a London-based specialist in high-yield debt at Bluebay Asset Management.
High-yield corporate bonds slumped to the lowest in more than a year during December in the U.S. and Europe, as investors took fright at the prospect of higher rates. They’ve since rebounded and have reached new peaks in the U.S., according to Bloomberg Barclays Indexes.
But while valuations have rallied, cracks are emerging. The number of corporate bonds in Europe trading at less than 90 percent of face value has jumped to almost 11 percent of the Bloomberg Barclays High Yield Index. A year ago, the rate was 2 percent.
The policy makers sounding the alarm are worried about more than just the absolute amount of debt. Carney and others highlight a trend toward borrowers stripping out limitations on how much they can borrow, known as covenants.
Ultra-low interest rates since the last financial crisis made it harder for investors to find assets that pay the yields they need to meet obligations to pensioners and insurance clients, forcing them to take on riskier assets. That’s created a sellers’ market, and more than 80 percent of European leveraged loans are ‘covenant-lite’, up from around half in 2015, according to data compiled by Bloomberg.
Carney added his own caveats to comparisons with the subprime crisis. “The main holders of leveraged loans can generally bear the risks” and are less reliant on short-term funding, unlike some holders of mortgage-backed securities a decade ago, he said.
Policy makers at the Federal Reserve and the European Central Bank are also wavering in their determination to raise borrowing costs, making the prospect of mass distress among indebted companies more remote.
The rate of defaults among companies is low, at less than 2 percent, with S&P Global Ratings and Moody’s Investors Service both forecasting a modest rise to about 2.5 percent this year.
But that’s little comfort to some.
“If there’s no covenant, it’s difficult to fail a covenant test -- that’s why default rates are low,” said Patrick Marshall, head of private debt and collateralized loan obligations at Hermes Investment Management in London. Marshall said he’s focusing on lending to medium-sized businesses where investor protections are stronger.
“If 2007-2008 was midnight in the party, now it’s 11 o’clock,” he said.
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