Complacency Breeds $2 Trillion of Junk

Will investor overexuberance cause debt markets to turn 'very ugly' very fast?

These are boom times for complacency. To gauge just how comfortable the world of debt has gotten, consider:

  • Bond buyers handed $2 billion last month to Ecuador, whose socialist president forced a default during the financial crisis while calling creditors “true monsters.”
  • So many investors piled into a May bond sale by Clear Channel Communications Inc. that the radio broadcaster, with a credit rating that implies default is almost a certainty, more than doubled the offering to $850 million.
  • China’s Logan Property Holdings Co. defied predictions of a slowdown in the nation’s real estate market by selling $300 million of bonds in May. The developer has negative cash flow and total debt almost twice its cash and cash equivalents.
  • Hellenic Petroleum SA in Greece, where the government has needed two bailouts in the past four years, borrowed the equivalent of $444 million last month. Lenders were so enthusiastic that they put in orders exceeding $1.37 billion.
  • Florida’s Orange County Industrial Development Authority issued $64 million of unrated debt last month to fund facilities near Orlando that convert sewage into fertilizer.

“It definitely feels like investors are getting overexuberant, and you can stay in overexuberant conditions for a while,” said Fred H. Senft Jr., director of fixed income and equity research for Key Private Bank in Cleveland. “But when it turns, it will turn quickly and it will turn very ugly.”

Halfway through a sixth year of near-zero interest rates by the Federal Reserve and unprecedented central-bank stimulus from Brussels to Tokyo, almost any borrower is able to raise debt with few questions asked, even as the World Bank cuts its outlook for global economic growth.

The value of bonds in the Bank of America Merrill Lynch Global High Yield Index has soared to more than $2 trillion. It took 12 years for the gauge, started at the end of 1997, to get to $1 trillion and only four years to add another $1 trillion. More than $338 billion of the debt has been sold this year, putting 2014 on track to top last year’s record $477 billion.

Investors who say they have no choice but to seek ever-riskier securities to generate any type of return are buying junk bonds and loans at a pace suggesting low default rates have blinded them to the potential minefields ahead. Even Japan’s risk-averse $1.25 trillion Government Pension Investment Fund said it’s considering loosening its practice of only buying investment-grade debt and venturing into junk bonds.

 

Easy Money

So eager are investors for the debt that borrowers increasingly are dictating their own terms. A measure of the strength of junk-bond covenants that are written into offering terms to protect buyers is about the weakest since Moody’s Investors Service started tracking the data in 2011.

After pumping trillions of dollars into the global economy to end the financial crisis, central bankers say they’re worried that investors are too complacent, increasing chances for future market instability. A measure of risk that uses options to forecast volatility in equities, currencies, commodities, and bonds has fallen to its lowest level on record.

“The market has been picked over,” and to get more yield, money managers may need to “add more risk or seek opportunities that may be less liquid,” said Jason Rosiak, the head of portfolio management at Newport Beach, California-based Pacific Asset Management, which oversees about $4.4 billion. “The portfolio manager needs to decide what is worth the price of admission.”

The warnings are growing louder and more numerous. Fed Chair Janet Yellen told reporters last month she was concerned about “reach-for-yield behavior.” Bank of England Deputy Governor Charlie Bean said conditions were “eerily reminiscent” of the pre-crisis era. Bundesbank board member Andreas Dombret said last month, “We do see risks, despite the fact that the markets are calm.”

The Bank for International Settlements (BIS) in Basel, Switzerland, said in its June 29 annual report that central bankers shouldn’t moan too loudly about complacency because they’re responsible. Record-low rates and unconventional monetary easing by the Fed, European Central Bank (ECB), and the Bank of Japan reduced price swings across markets, the BIS wrote in the report.

 

No Worries

It isn’t hard to see why investors are expressing little concern. The Fed has injected more than $3 trillion into the global economy through its bond-purchase programs. The ECB cut its deposit rate to minus 0.1 percent in June and has provided about $1 trillion of emergency loans to banks. Japan’s central bank has been buying about 7 trillion yen (US$69 billion) of bonds per month through its own quantitative-easing measures.

Investors in junk bonds have enjoyed a return of 157 percent since the depths of the 2008 financial crisis as measured by Bank of America Merrill Lynch indexes. That’s better than the 123 percent for the MSCI All-Countries World Index of stocks.

Central banks’ largesse means borrowers that would have otherwise defaulted have been able to refinance and extend maturities, giving lenders few reasons to worry. The global default rate fell to 2.3 percent in May, according to the most recent measure from Moody’s. The firm sees the rate rising to 2.4 percent next year, still about half the historical average of 4.7 percent.

The day of reckoning may be within view. Junk-rated borrowers have $737 billion of debt due in the next five years, peaking in 2018 with the most maturities since just after the financial crisis, Moody’s said in a Feb. 4 report. High-yield borrowers are rated below Baa3 at Moody’s and below BBB- at S&P.

For the first time, more than half of the junk-rated loans made in the U.S. are covenant-light, meaning they lack typical lender protections like limits on the amount of debt they can amass relative to earnings.

Once the market turns, losses may be exacerbated as investors jam into exits already narrowed as banks commit less capital to facilitate trading.

Yet investors keep accepting less to take on the risk that companies will make good.

Since peaking at 23.2 percent at the end of 2008 during the depths of the financial crisis, yields tumbled to a record 5.6 percent last month, Bank of America Merrill Lynch index data show. At one point, they fell within 3.6 percentage points of benchmark government bonds, the smallest gap since 2007 and 2.5 percentage points below the average of the past decade.

“It’s about as extreme as it gets,” said Martin Fridson, a New York-based money manager at Lehmann, Livian, Fridson Advisors LLC, who started his career as a corporate-debt trader in 1976 and estimates yield spreads are about 2 percentage points too tight. “Yields are so skimpy, and we are in a period of financial repression.”

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