Distressed businesses are meager on the ground these days. This has been good news for investors in an important corner of the financial system.
Owning the riskiest corporate debt in the United States and Europe has provided positive returns so far this year for bond investors, a rare bright spot in the vast universe of publicly traded debt.
In contrast, holders of higher quality bonds sold by governments and corporations recorded negative returns in 2021. This is due to expectations of higher interest rates as inflation and economic growth grow. are accelerating. As rates rise, existing bonds are less attractive to investors than new debt offerings.
The disparity in performance between high-grade debt and low-grade debt may seem odd given that the overall rise in bond yields this year is expected to hit struggling companies more. One explanation lies in the behavior of the markets once the economic recovery is underway.
As the risk of corporate default decreases, stocks and debt sold by so-called “junk” companies with lower quality balance sheets recover sharply – as was the case in 2009 and 2003 when high yields fell. is highly valued following the spike in defaults and late recessions.
“Default rates have come down a lot and companies have refinanced their debt at lower rates and if we get the expected rebound in earnings, the high yield can hold up next year,” says Adrian Miller, chief market strategist at Concise Capital, an asset manager. specializing in small business debt.
Indeed, this week, Fitch Ratings forecasts a drop in the expected rate of default of speculative rated companies this year to 2% against 3.5% in 2021, far from the peak of 14% observed in 2009.
With reduced fear of default, the higher fixed borrowing rates paid by lower-grade companies suddenly look attractive compared to the relatively meager offerings of blue-chip rated bonds.
This week, BlackRock said investor demand for high yield market income contributed to their strong client inflows during an impressive performance by the asset manager in the first quarter.
The need for income helps explain another quirk in today’s high yield market. The risk premium or spread associated with owning the lowest quality credit has declined significantly relative to that of US government bonds.
The gap narrowed to the lowest levels seen in the decade following the financial crisis. Moreover, it happened after the sale of a record $ 140 billion in junk bond debt in the first three months of the year. Bank of America forecasts $ 475 billion in debt sales in 2021, a 10% increase from a record 2020.
The ability of companies to borrow such amounts and not send significantly higher interest rates reflects the seemingly insatiable demand for income by investors betting on defaults remaining low with a strong global economic recovery in the past. the day after the pandemic.
Still, the speed and scale of the high yield debt rally does little to allay long-term fears that the credit market has far outperformed the underlying fundamentals of low-quality companies.
It intervenes in a context of low capacity utilization rate by American companies. In previous decades, this reflected a lot of economic downturn and thus pointed to growing challenges for businesses.
Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors, says there is hidden distress in the high yield debt market. He says even higher-rated companies have been pushed past fair value thanks to the US Federal Reserve’s huge support for markets and credit flow.
This intervention by the Fed should make investors wary of the possible long-term consequences. There remains considerable doubt as to the extent of the post-pandemic recovery beyond this year for indebted companies.
Fitch, for example, has a slightly higher 2022 default rate forecast than this year, “reflecting uncertainty over the sustainability of the recovery in demand for some sectors.” This is in part due to the persistence of digital trends that have challenged a number of industries.
Tracy Chen, portfolio manager at Brandywine Global, a Franklin Resources investment boutique, says, “Business models will change after Covid and many companies are still supported by accommodative policies.
“Stimulus and infrastructure spending is good for some sectors. Longer term, we are less optimistic about high yield. “
This view reflects doubts as to whether the stimulus measures breathe new life into some companies or delay a possible debt calculation.
“Before Covid, investors were very cautious about credit and talked about the end of the cycle,” Chen says.
“There is a case where a larger default cycle has been delayed and occurs within the next 12-18 months after the stimulus has ended.”