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 US 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 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 under way.
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 2009 and 2003 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, an asset manager specialising in small company debt.
Indeed, this week, Fitch Ratings forecast 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.
This week, BlackRock said demand for income in the high-yield market from investors contributed to their 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 US government bonds.
The spread has eased towards the lowest levels seen during the post financial crisis decade. Moreover, it has occurred after a record $140bn of junk bond debt was sold during the first three months of the year. Bank of America forecasts $475bn 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…
Read More: The bright spot in strained bond markets