Junk Bonds With Low Yields? Here’s Why They’re Hot

(Bloomberg) -- High-yield bonds that don’t pay very much? Sounds like an oxymoron, or maybe unwise. But investors are pouring money into what are also known as junk bonds -- debt issued by companies with less-robust finances that traditionally have paid higher interest rates to compensate for the extra risk. This month, the average yield on U.S. speculative grade debt fell below 4% for the first time ever. To some, that’s a sign that the Federal Reserve’s ultra-loose monetary policy is working as planned. To others, it’s a sign that good judgment has taken a back seat to investors’ thirst for yield.

1. What’s driven junk yields this low?

Investment-grade bonds were pummeled when the pandemic shut economies around the world in March 2020 but quickly rebounded thanks to unprecedented action by the Fed to support credit markets. But with safer bonds providing next-to-no compensation for those holding them, investors turned to riskier debt for better returns, even though a large number of junk-rated companies were in sectors like retail and hospitality that were hit especially hard in the pandemic. In many ways, this was an extension of the phenomenon known as “the reach for yield” that began after rates fell to near-zero after the financial crisis in 2008.

2. Who’s still buying junk, and why?

Even when the stock market is booming, not all money goes into equities. Many money managers have mandates to invest in a diversified portfolio spread across different types of equity and fixed income. (Remember learning about the 60/40 portfolio? That 40% in fixed income can often include high-yield bonds.) And even with their yields down, junk bonds still look relatively attractive compared to other credit asset classes, returning 1.17% through Feb. 23, compared with a 3.14% loss in investment-grade bonds. For foreign buyers, U.S. corporate credit looks attractive compared with the $14 trillion of negative-yielding debt in other parts of the world.

3. Who’s issuing junk bonds?

Companies hit hard by the Covid-19 pandemic are among the biggest beneficiaries of the current market. In fact, there’s been so much demand for high-yield debt -- even the Fed talked in April about buying some -- that such firms have been able to borrow money at much lower funding costs than normal, allowing them to raise liquidity and lock in cheaper interest rates on their debt. For example, Carnival Corp. raised a $3.5 billion bond in early February that saw its size increase and its pricing fall as it was being marketed to big investors, thanks to relentless demand. This was the fifth time the cruise operator raised bonds since the start of the pandemic. In April, the company had to offer an 11.5% coupon and promise its ships as collateral. The latest deal, which didn’t have the protection of being secured by special assets, sold at a 5.75% coupon. Energy companies rocked by a swoon in prices in 2020 were also helped by the boom in junk bonds.

4. How hot is the market?

A growing number of credit investors feel compelled to pour into nearly every new bond deal that comes to market. Some are even calling up companies or their bankers to push them to issue more junk bonds, rather than just wait for deals to come their way. They have to fight to put money to work as demand in the asset class far exceeds supply. Many deals are receiving so many more orders than the originally intended size that companies have been able to increase the offering and lock in lower coupons.

5. Why is that?

Along with factors like portfolio allocation, investors are also betting on a strong recovery in the second half of 2021, and trading levels already reflect this thesis. For example, some of the largest money managers such as BlackRock Inc. and Vanguard Group Inc. expect mass vaccine distribution, federal stimulus and pent-up demand from lockdowns to boost industries like transportation, leisure, energy and the financial sector.

6. What does the Fed have to do with this?

During a downturn, especially one that put the economy on temporary life support as Covid did, companies need access to credit more than ever. But it’s also when lenders would rather take fewer risks and stick to buying Treasuries or other safer assets, all other things being equal. The Fed tries to change that equation not only by lowering rates to make borrowing easier, but by instilling confidence in the market so that investors feel comfortable lending credit to riskier companies. The surge in junk lending is consistent with the central bank’s goal of helping companies that were solvent before Covid stay afloat till the health crisis eases. Just knowing the Fed was there to backstop was enough to put many investors in a bullish mood about the markets -- including the shakier parts of corporate credit.

7. Is this a risky development?

There are some reasons to be sanguine, including widespread belief in the Fed’s readiness to step up again if needed, drops in Covid rates and a ramping up of vaccinations. Default rates have come down from the start of the pandemic, thanks to ample liquidity. Meanwhile junk companies in the U.S. are seeing their ratings increased in droves, with upgrades so far this quarter reaching the highest level relative to downgrades since the end of 2013, according to data compiled by Bloomberg. All told, the universe of troubled loans and notes is down to about $110 billion as of Feb. 22, compared with nearly $1 trillion last March, data compiled by Bloomberg show. And many recent borrowers that were distressed just a few months ago now can easily access the capital markets.

8. What’s the other side of the argument?

Few market participants expect any sort of major systemic risks with the shift toward riskier credit, due to a strong economic outlook and the extensive support from the Fed. However, junk yields this low reflect an assumption that a strong economic recovery is on the way. But the emergence of more transmissible variants of the coronavirus is a reminder that even with vaccines in hand, the evolving virus could have more unhappy surprises for the world. If forecasts don’t pan out, there’s lots of room for junk bonds to sell off. Companies that have borrowed heavily to stay afloat during the pandemic could be dragged down by that debt.

9. If high yield is low yield, what’s the alternative?

The fall in junk bond yields has made other asset classes more attractive to investors, including some that are less liquid, meaning potentially harder to sell in a crunch. For example, senior loans in private debt deals -- where small groups of investors lend directly to companies -- yield about 7% on average, according to a Feb. 10 report from private-markets investment firm Adams Street Partners. They typically carry a yield of about 200 basis points above high-yield bonds or leveraged loans, the report said.

The Reference Shelf

• Bloomberg News stories on junk-bond yields falling below 4% and on investors who push companies into borrowing more.
• An article on the cycle of credit upgrades now underway.
• QuickTakes on “fallen angels” and how the Fed moved to support them.

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