The junk bond bubble

The extraordinary monetary accommodation by central banks across developed economies has been criticized for laying the seeds for another round of resource mis-allocation in the financial markets. It has been blamed for inflating speculative bubble in commodities markets. The latest signal of market distortions comes from junk bond yields which have fallen to its lowest rate ever, declining below the 6% mark.

This has forced the FT to question the wisdom of even calling them "junk" bonds. It writes,

To put this in perspective, junk yields peaked at almost 23 per cent during the financial crisis and have traded at a median of 8.2 per cent over the last decade. Current junk yields are closer to investment grade bonds’ 10-year median of 4.7 per cent... The yield on the 10-year Treasury... remains below 2 per cent. Investment grade bonds yield 2.8 per cent, on average. Top-rated 10-year municipal bonds are paying 1.8 per cent. All three are near historic lows. So bond investors fleeing the craziness of junk bonds will not find much sanity elsewhere, and junk, at least, tends to be less vulnerable than other bonds to losses when rates rise.

The ultra-low interest rates have driven down returns on all but the high risk securities. Investors in fixed income securities have responded by driving up the prices on these high risk junk bonds. According to The Bank of America Merrill Lynch High-Yield Master II Index, junk yields have fallen to 5.975% from 8.24% at the beginning of 2012 on the back of a 15.58% increase in their values this year. Junk bond issuance too has been rising in recent years. A record $79 billion in high-yield corporate bonds were sold in the United States in the third quarter. 

As yields fell, prices climbed, from 98.1 cents on the dollar at the start of 2012 to 104.75 now, near the all-time high of 104.99 recorded in January 2004, and above the key call-constrained 103% level that once served as a reliable upper boundary. Corporates too have been using the low rates to raise capital for retiring off their older, higher interest rate capital. Junk bonds have been on a rising path over the past four years, increasing by 4.4%, 15.2%, and 57.5% respectively in 2009, 2010, and 211 respectively. 

However, fortunately, there is a limit to how much junk bonds may rise. They can be redeemed early, from halfway through their life and starting at par plus half of the coupon. With average coupon of 8%, the redemption price comes to about $104, lower than the current pricing of $105. 

But for now, investors and financial institutions are piling on the risk as they see junk bonds as the only fixed income instrument offering attractive enough returns. Its immediate beneficiaries are the weaker companies, whose debt generally would have had to be priced at high premiums, who now are able to raise capital at much lower rates. 

Amidst all this, it cannot be denied that riskier bonds cannot become any less risky just because the market thinks that the cost of carrying it can be lower.