Despite Fed Backstop, Junk Bonds Still Face Big Trouble
Hallelujah. Deliverance. Junk bonds were spiraling into the abyss until late March, then the Federal Reserve created a backstop for them that ended the nightmare. The bonds’ prices improved markedly. New junk issues over the past few weeks are again hugely popular with investors.
That means high-yield debt securities are safe, right?
Ummm, maybe not. While nobody knows the future course of the coronavirus outbreak, the US is without doubt descending into a bad recession. One that will severely damage the finances of highly indebted (read: junk-rated) companies.
Furthermore, the much-vaunted Fed backstop for junk is not that great, at least not now. Wall Street was thrilled to hear that the Fed would buy junk bonds, supporting their prices. Hold the applause. A mere handful of junk issues qualify for Fed purchases. The vast bulk of junk bonds are ineligible, sort of like having a pre-existing condition and getting denied health coverage.
“It’s premature to say that the market has stabilized and will be buoyant in the future,” said Edward Altman, the nation’s leading authority on high-yield and a professor emeritus at New York University. “The Wall Street folks seem to ignore the dire forecast for the real economy, which of course will impact corporate performance, especially cash flows.”
Making matters worse is that a lot more junk bonds are around these days, totaling $1.5 trillion, a doubling from 10 years before. That swelled issuance increases the odds of catastrophic losses.
Also ominous is the expansion of BBB bonds, the bottom rung of investment grade. BBBs constitute a full half of investment grade issues, raising the strong possibility that a bunch of them will be downgraded to junk. Scott Minerd, the Guggenheim Partners CIO, estimates that $1 trillion of the BBBs are at risk of a demotion to speculative grade, which would increase their borrowing costs.
The chief reason for the proliferation of junk and near-junk issues: tiny interest rates that have prevailed since the 2008-09 financial crisis, encouraging companies to load on debt. With a low high-yield default rate—at the start of 2020, averaging just 2.9%, by Altman’s count, below the 3.3% historical mean—the risk of buying junk bonds seemed minuscule.
The Dreaded Spread
Not anymore. US high-yield defaults may average 12.7% by this year’s fourth quarter, according to Moody’s Investors Services. That’s a big hike. During the last recession, high-yield default levels climbed to 10.7%, by Altman’s estimate. For the two downturns before that, they topped out at 12.8% in 2002 and 10.3% in 1991.
This year’s wild fluctuation in the spread between junk and safe U.S Treasury bonds tells a disconcerting story. The narrower the spread, of course, the less risky junk seems to investors. The low-risk narrative was in full force as 2020 started, with the spread at a mere 3.6 percentage points. “You weren’t paid to take risk,” recalled Christian Hoffmann, a portfolio manager at Thornburg Investment Management.
Junk Bonds’ Extra Yield vs. Treasuries
Percentage points
12
Government Rescue Packages Announced
10
8
6
Oil Prices Collapse
4
Virus Infections Rise in US
2
1/1
1/15
2/1
2/15
3/1
3/15
4/1
4/15
5/1
Percentage points
12
Government Rescue Packages Announced
10
8
6
Oil Prices Collapse
4
Virus Infections Rise in US
2
1/1
1/15
2/1
2/15
3/1
3/15
4/1
4/15
5/1
Percentage points
12
10
8
6
4
2
1/1
1/15
2/1
2/15
3/1
3/15
4/1
4/15
5/1
3/2
Virus Infections Rise in US
3/23
Government Rescue Packages
Announced
Oil Prices Collapse
4/21
Percentage points
12
10
8
6
4
2
2/1
3/1
4/1
5/1
1/1
3/2
Virus Infections Rise in US
3/23
Government Rescue Packages
Announced
Oil Prices Collapse
4/21
Source: ICE BofA US High Yield Index Option-Adjusted Spread
As the coronavirus began its deadly march around the world, the spread widened to 5.0 points in early March and peaked at 10.8 later in the month. No new junk bonds were put on sale, as no one wanted to buy. That’s when the Washington cavalry came thundering onto the scene to save the day.
Once the enormous multi-trillion-dollar fiscal and monetary efforts were announced, with special aid for junk, the spread contracted to 7.6 in mid-April. Subsequent events have nudged that up to 8.0: Oil prices took a freaky dive, endangering a major US industry; one-tenth of junk issues are in the energy realm. Junk energy bonds had doubled in value over the past decade, reaching an apex in February. Now, they’re down 28%, the S&P 500 High Yield Energy Corporate Bond Index indicates.
Still, that overall oil-slump-driven junk spread widening was relatively minor. That’s a testament to the now-ubiquitous Wall Street belief that the government and the Fed will keep marshaling their considerable power to save the economy and the markets.
The descent and partial rebound of junk has been as sudden as the onset of the virus. “We are entering what no one has seen in our lifetimes,” said Mike Kirkpatrick, senior portfolio manager at Seix Investment Advisors. And that suggests even more wrenching changes ahead.
The Fed to the Rescue?
What’s amazing is how much optimism is prevailing in the high-yield market now, thanks largely to the Fed’s backstop. With the central bank’s policy announcement, a record $7.8 billion in new money poured into junk bond funds, Bank of America reports.
Faced with an unknowable future, debt-burdened companies are eager to gather as much cash as they can, so they are offering new bond issues. The fact that those below-investment-grade offerings are welcome to the new-issue party is remarkable, given junk’s recent skunk status.
Investors lately have paid millions for the high-yield bonds of companies with disconcertingly hefty balance sheets. Moody’s lowered the junk rating for US Foods Holding five notches last week, around the same time as the food distributor sold $800 million in senior secured notes. Embattled casino operator MGM Resorts, its gambling properties shuttered, recently sold $500 million in unsecured bonds.
Gap, the long-suffering apparel retailer, managed to float $2.25 billion in unsecured bonds, even though the company says it must skip $115 million in April rent payments for stores and other properties. The bond proceeds will be used to pay down existing debt and to restock depleted cash coffers. Gap has exhausted its entire bank credit line and warns that it might run out of cash before year-end. (The three bond sellers didn’t return requests for comment.)
None of this would be possible without the Fed’s intervention. The Fed surprised everybody with its late-March announcement of a foray into buying corporate bonds, which it had previously eschewed as too risky. “The Fed showed us it wasn’t out of powder,” said Matt Daley, head of corporate and municipal teams at Conning. “It became more creative.”
Trouble is, the Fed’s efforts to support junk bonds are very limited. All investment grade paper is cleared for central bank purchases. But when it comes to junk, the bank has restricted buying to “fallen angels,” bonds booted out of investment grade to the nether regions of high-yield. The vast bulk of junk bonds are ineligible.
That’s not all: Only fallen angels that got downgraded after March 22 (when the new policy was announced) can qualify. Thus, Occidental Petroleum and Kraft Heinz, lowered to junk before then, get no Fed backing. But Ford Motor, which fell into the junk pile on March 25, can benefit from the central bank’s generosity.
In fairness, the Fed backstop does aid the entire junk market in a round-about way. It also plans to invest in junk exchange-traded funds (ETFs). Alas, these ETFs, which buy the speculative bonds, have assets of just $61 billion, records from the ETF Database show. This sum is a paltry 4% of the entire junk sector.
None of this is to say that the Fed couldn’t enlarge its junk-saving scope later, if things really went to hell.
The Spunk in Junk
Indeed, the case for high-yield as a long-term investment still holds. If around 13% of the present crop of junk defaults, that means 87% of them won’t. While these non-defaulters surely will fall in price when recession storm clouds open up, they still deliver attractive interest rates for folks weary of skimpy fixed-income yields.
A massive wipe-out for the junk category is far-fetched, although when high-yield is in trouble, you’d think this was a real possibility. “People thought defaults in the financial crisis would hit 25%,” said Jim Schaeffer, global head of leveraged finance at Aegon Asset Management. “That didn’t happen.”
What’s more, if a high-yield company drops into Chapter 11 or an out-of-court restructuring, money can be made there, too. When the junk bond boom of the 1980s collapsed in 1990, sharp investors such as Leon Black scarfed up the damaged merchandise and profited handsomely once the paper recovered. History is likely to repeat itself.
For the pros today, plenty of ways exist to profit from a wobbly junk market. Consider the $1.5 billion in high-yield bonds that Bed, Bath & Beyond floated in 2014. The struggling home-items retailer was losing money before the virus shutdown.
Patrick Faul, director-research at LM Capital Group, pointed out that most of these bonds (the issue has three different maturities) are changing hands at 40 cents on the dollar. That is, they can be purchased on the cheap. If the company went into restructuring, he believes that bond investors would come away with more than 40 cents.
As Bill Getty, a managing director at Makena Capital, put it: “Longer-term investors are uniquely well-positioned to invest in distressed assets due to a longer horizon and greater ability to underwrite and hold assets through a restructuring process.”
In fact, junk’s performance over time is pretty decent. The BlackRock Investment Institute calculates that, over the past 10 years ending in March, high-yield was the third-best asset class, returning an annual 5.1%. Only stocks and real estate investment trusts performed better, at 10.5% and 6.3%, respectively. Investment-grade bonds came in seventh, at 3.8%.
The demand from corporations that don’t qualify for conventional financing will not go away. Michael Milken, a controversial figure from the 1980s who is the father of the junk market, realized that these bonds serve a vital purpose. Current important industries, such as telecommunications, got their start in Milken’s day, courtesy of junk. “The high-yield market,” said Peter Knapp, a bond market analyst at Informa Global Markets, “is a lifeline for many companies.”
In the meantime, however, the lifeline looks frayed. There’s a standard comparison made between junk bonds and stocks: They both tend to move in the same direction. In other words, they can encounter some really rough times. One such time lies ahead.
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