The media is currently doing its level best to scare junk bond investors. There have been many analyst and media warnings lately about the pending fall of high yield bonds (some of which we have featured). Most argue that in an economic downturn, BBB bonds will suffer. Others says there has been no rise in underlying performance to justify the rise in prices. Others have focused on CCCs and their movements. Initially the worry was that CCCs had not rallied like the rest of the market, which was taken as a sign of deteriorating credit conditions. Now the media is warning (see Barron’s) that since they have rallied, it is again a warning sign.
FINSUM: Everything is a warning sign! Our own feeling is that we are generally moving toward a more risk-on environment and the trend for high yield is improving as the economic outlook does.
There are some very worrying signals coming out of the high yield sector. In particular, stocks at the riskiest end of the market have been underperforming. Bonds rated CCC, CCC+, and CCC-, which are the three lowest rungs before default, have been underperforming all year and that weakness has now reached an “unprecedented size”. What is worrying is that very lowly rated bonds are usually the most influenced by economic perceptions, and it is unusual that with junk rallying so much this year that this cohort has not taken part.
FINSUM: So there are two options for what this could mean. Either it means investors are just being cautious, or much more negatively, that credit conditions are tightening, which would be a sign of a pending economic downturn.
If the Fed isn’t stimulating high yield bonds, then they might be highly risky and extraordinarily overpriced. High yield bonds spreads have narrowed significantly versus Treasuries in recent months, a very odd move given the worries about the economy (which usually hurt junk bonds). Some think the Fed may be buying such bonds, which would drive prices up and yields down. Spreads are down 110 basis points this year.
FINSUM: If everyone was so worried about the economy—which would usually push Treasury yields down and junk bond yields up—then how could spreads have narrowed between the two? Something smells wrong here.
Banks across the country are under pressure, and it is starting to show. Four US banks have failed already this year (three in the last month) compared to zero last year. The reasons why are many, but low interest rates and strong competition have been impacting the space. The four bank failures do not seem to be due to a particular asset class, but particular idiosyncratic circumstances. Still, as mortgages have seen lower rates, banks are more and more likely to move into more risky areas to boost yields.
FINSUM: In 2006 there were zero bank failures, in 2007 there were three, in 2008 it was very ugly. We do not think we are going down the same rode, but it is a sign worth noting.
For many months there has been a great deal of fear about the threat of BBB bonds falling into the “junk” category. The whole fear is based on the idea that as the economy slows, this huge group of companies would get downgraded and there would be forced divestiture, sending bond prices strongly lower. However, the opposite has happened. Over the last few months, BBB bonds done nothing but strengthen. In fact, the spread between BBBs and Treasuries just hit a 52-week low, showing investors renewed faith in what is the largest segment of corporate bonds.
FINSUM: Unsurprisingly, the price growth has led to a bunch of new issuance. It is important to remember that though prices have risen, the risk of a recession and downgrades is still very much there.