Usually a beneficiary of low interest rates, junk bonds — riskier corporate bonds rated below investment grade — were one of the top-performing assets in 2010 and the early part of this year, thanks to their rich yield offer in a low-return world.
Junk companies have also benefited from the extremely low default rate — which hit a 3-year low of 2 percent on S&P’s measure. This is because their balance sheets stayed healthy thanks to favorable financing conditions, at a time when banks and governments suffered from deteriorating credit quality.
However, the fortunes of junk bonds are turning as concerns grow that low-grade corporates may become the first to suffer from the slowing economy that would push up their default rates.
Moreover, investors may be forced to abandon junk bonds to adjust upwards the average rating of their credit portfolio after sovereigns, most recently the US, lose top-A ratings and more are feared to follow suit.
“The move from excessive lending to a more realistic situation requires restructuring, defaults and bankruptcies — all of which happen in a normal credit cycle. If you have a period of weak growth that will make the process harder,” said David Miller, partner at Cheviot Asset Management.
“The yield pick-up you get in junk relative to investment grade is not enough to justify the risk.”
The Federal Reserve’s pledge late on Tuesday to keep interest rates near zero for two more years offered little respite.
Despite a rise in other risky assets after the Fed statement, the spread of global high-yield corporate bonds over benchmark rates went on widening to hit 728 basis points — its highest since June 2010.
This spread, measured by Bank of America Merrill Lynch, has widened nearly 180 basis points in just two weeks.
The BofA ML global high-yield index posted total returns of 14.7 percent in 2010 and 5.9 percent in January to May, before making a loss of 3.5 percent in the past three months.
Investors withdrew $804.3 million from high-yield funds in the week ending Aug 3, erasing the previous two weeks of inflows, according to Lipper. EPFR data showed high-yield funds saw $1.13 billion of outflows in the week to Aug 5.
There is also evidence that the pace of issuance is slowing. In July, US junk bond issuance posted this year’s lowest monthly volume of $17.5 billion in July, nearly half the average monthly volume seen between August 2010 and May 2011.
Barclays Capital calculates that the inflection point for US high-yield bond returns has historically been economic growth of 0.5-1.5 percent.
When growth slips below that level, high-yield returns in the preceding quarter have tended to be low or negative, particularly for lower-quality credits.
Conversely, GDP growth in excess of 1.5 percent has historically been preceded by strong returns across all quality levels.
Economists polled by Reuters expect the US economy to grow 1.8 percent this year, although they put at one-in-four the chances of a return to recession.
“Disappointing first-half 2011 GDP numbers have prompted concerns that second-half growth may be insufficient to allow high-yield issuers to reduce leverage and grow into their capital structures,” the bank said in a note to clients.
Barclays also recommended investors to adjust risks within their high-yield portfolio.
“Given slower growth expectations, investors should also consider adjusting their risk by moving up the quality spectrum, as BB issuers, particularly those which have positive ratings momentum, are much better positinoed to weather a prolonged soft patch than their lower-quality counterparts,” it said.
The default rate for high-yield corporates remains low still, but slower economic growth is expected to hit the ability of lower-rated companies to service their debt.
JP Morgan, which uses a different gauge from S&P, expects the US high-yield default rates to rise to 1.5 percent in 2012 and 2.0 percent in 2013, from the current 1.05 percent.
“The default rate in junk bonds will have to go up. In this environment you just don’t buy more junk,” said Philip Poole, head of global and macro strategy at HSBC Global Asset Management.
