Wall Street does not like the term “junk bonds;” they prefer to refer to them as ”high yield bonds.” Junk bonds are debt securities rated below Investment Grade by the three major rating agencies (defined as a Nationally Recognized Statistical Rating Organization such as S&P). Over the last 20 months investors have been investing a significant amount of money into junk bonds in search of yield. With Treasury and corporate bonds experiencing abnormally low yields, investors are getting desperate and greedy for more income.
Below is a table from Oaktree Capital Management, L.P. on the history of junk bond yields and the differences over US Treasury bonds ( 100 basis points is 1%, so 1773 basis points is 17.73%). What is noteworthy is how investor yields are declining and the yield difference compared to US Treasury bonds is also shrinking. This means that junk bond investors are currently taking on more risk and receiving less return.
| Yield to Maturity | Spread vs. Treasurys | |
| “Normal” – Dec 31, 2003 | 8.2% | 443 b.p. |
| Bubble peak – June 30, 2007 | 7.6% | 242 |
| Panic trough – Dec 31, 2008 | 19.6% | 1773 |
| Recovered – March 31, 2010 | 9.0% | 666 |
| Shrinking again – April 30, 2011 | 7.5% | 492 |
Junk bonds swing from greatly overvalued to undervalued. The middle ground does not last a long time. From 2005 to 2007, investors in junk bonds focused on the risk of missing opportunities rather than analyzing the junk bond as offering a good balance of risk vs. reward. Then came the financial crisis. Today investors can see evidence of some of the excesses from the bubble years creeping back – payment-in-kind bonds, covenant-lite debt, rising leverage ratios of completed buy-out deals and more leveraged buy-out activity. Although the irrational exuberance exemplified in the financial markets between 2005 and 2007 is not representative of today, in a low interest rate environment investors should be careful not to make “handcuffed” investment decisions (people making decisions on the belief they have no choice.) Investors always have a choice. Additionally, many of the companies that were responsible for leveraged buy-out deals occurring in the 2005-2007 time frame are re-issuing their junk bonds, and these junk bonds are not necessarily being issued on “investor-friendly” terms. Consequently, those deals also find their way into junk bond funds.
Bottom line: Junk bonds are no-longer a “cheap” investment . Investors allocating money into junk bonds in today’s low interest rate environment should be cognisant of what is occurring with private equity restructurings and deals in the leveraged buy-out space.
Always Asking, Never Assuming™
Christopher Holtby