The bright spot in strained bond markets

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Troubled companies are thin on the ground these days. That has been good news for investors in an important corner of the financial system.

Owning the debt of the riskiest companies in the U.S. and Europe has provided positive returns so far this year for fixed-income investors, a rare bright spot in the vast universe of publicly traded debt.

By contrast, holders of higher-quality bonds sold by governments and companies have experienced negative returns during 2021. That has been driven by expectations of higher interest rates as inflation and economic growth pick up. As interest rates rise, existing bonds are less attractive to investors compared with new debt offerings.

The disparity in performance between high- and lower-quality debt may appear strange given that the overall rise in bond yields this year might be expected to hit strained companies more. An explanation rests in how markets behave once an economic recovery is underway.

As corporate default risk abates, shares and debt sold by so-called “junk-rated” companies with lower-quality balance sheets rally sharply – as was seen in 2003 and 2009, when high yield appreciated sharply in value in the wake of defaults peaking and recessions ending.

“Default rates have fallen a lot and companies have refinanced their debt at lower rates, and if we get the expected rebound in profits, high yield can hold up into next year,” says Adrian Miller, chief market strategist at Concise Capital Management LP, an asset manager specializing in small company debt.

Indeed, last week, Fitch Ratings Inc. forecasted a decline in the expected rate of speculative-rated company defaults this year to 2 per cent from 3.5 per cent in 2021. The pace of defaults has eased markedly from a projected 5.2 per cent a year ago and is nowhere near the peak of 14 per cent seen in 2009.

With reduced fear of default, the higher fixed rates of borrowing that are paid by lower-quality companies suddenly look attractive compared with the relatively meagre offerings by blue-chip-rated bonds.

Last week, BlackRock Inc. reported that demand for income in the high-yield market from investors contributed to its strong client flows during an impressive first-quarter performance by the asset manager.

The need for income helps explain another oddity about the current high-yield market: The risk premium or spread associated with owning the lowest quality credit has shrunk markedly versus that of U.S. government bonds.

The spread has eased toward the lowest levels seen during the post-financial crisis decade. Moreover, it has occurred after a record US$140-billion of junk bond debt was sold during the first three months of the year. Bank of America forecasts US$475-billion of debt sales in 2021, a 10 per cent increase from a record-breaking 2020.

The ability of companies to raise debt in such amounts and not send interest rates markedly higher reflects the seemingly insatiable demand for income by investors betting on defaults staying low with a robust global economic recovery in the wake of the pandemic.

Still, the speed and extent of the rally in high-yield debt do little to allay long-term concerns that the credit market has run well ahead of underlying fundamentals for low-quality companies.

It comes amid a low rate of capacity utilization by U.S. companies. In previous decades, this reflected plenty of slack in the economy and thereby indicated mounting challenges for companies.

Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC in New York, says there is hidden distress in the high-yield debt market. He notes that even better-rated companies have been pushed beyond fair value on the back of the huge support by the U.S. Federal Reserve Board for markets and the flow of credit.

That Fed intervention should leave investors wary about the eventual longer-term consequences. There remains considerable doubt as to the extent of the post-pandemic recovery beyond this year for indebted companies.

For example, Fitch Ratings has a slightly higher 2022 default rate forecast than this year, “reflecting uncertainty around the sustainability of the demand recovery for some sectors.” That’s due, in part, to the persistence of digital trends that have challenged several sectors.

Tracy Chen, portfolio manager at Brandywine Global Investment Management LLC, an investment boutique in Philadelphia that’s part of Franklin Resources, says that “business models will change after COVID-19 and there are still a lot of companies being supported by accommodative policies.

“Stimulus and infrastructure spending is good for certain sectors. Longer term, we are less bullish on high yield,” she says.

This view reflects doubts as to whether stimulus provides some companies with a new lease of life, or delays an eventual debt reckoning.

“Prior to COVID-19, investors were very cautious about credit and talking about the end of the cycle,” Ms. Chen says.

“There is a case that a bigger default cycle has been delayed and that it occurs over the next 12 to 18 months, once the stimulus measures have ended,” she adds.

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