Why everyone wants to lend to weak companies
Credit investors often talk in euphemisms. The safest bonds, with the highest credit ratings and hence the lowest yields, are almost always referred to as “high-grade” rather than “low-yield”. Conversely, the riskier stuff, where defaults are more likely, is politely dubbed “high-yield” rather than “low-grade”. Recently, though, the yield on supposedly high-yield bonds has not been all that high.
Indeed, on November 24th the spread (or extra yield) enjoyed by investors in American high-yield bonds over that enjoyed by investors in Treasury bonds fell below the spread on fixed-rate residential mortgages for the first time. Since high-yield bonds have a greater rate of default over the long term, these moves have left investors wondering what is going on.
Part of the explanation is that the spread on residential mortgages has ticked up. With the Federal Reserve cutting interest rates, investors have moved to price in the risk that mortgage-holders refinance their debts. However, the more dramatic action has been in high-yield credit spreads. The spread over Treasuries on high-yield bonds fell from 3.7 percentage points at the start of the year to 3.2 this summer. Since September it has fallen to just 2.6 points. It is now near the record lows reached just before the global financial crisis of 2007-09 (see chart 1).
The comparison is not entirely like-for-like. Since the financial crisis, private credit has boomed (see chart 2), with funds lending directly to firms rather than doing so through publicly traded bonds. The industry tends to take on the most desperate borrowers, meaning that such companies are no longer pushing up yields.
Yet the shift does reflect fast-changing sentiment. It is another part of the Trump trade that has gripped markets in the past month, sending American shares and the dollar soaring. The president-elect’s proposed corporate-tax cuts would be especially welcome for indebted firms, freeing up cash to meet interest payments. Fast, deficit-fuelled economic growth would also be a boon for such companies.
Credit strategists describe the mood among junk-bond investors as near euphoric. A survey of asset managers by Bank of America before the election found that a net balance of 1% expected high-grade debt to outperform high-yield debt in the coming months. After the election, a net 41% expect high-yield debt to do better.
Lower interest rates have also prompted a search for yield, with investors now considering riskier bets. Fund managers note that a year ago American investment-grade corporate debt offered yields of 6%, compared with 5.3% now. By contrast, lower-rated debt still offers around 6.9%. High-yield funds in both America and Europe have seen large inflows this year, pushing spreads lower. As they fall, they also reduce the risk of a nasty surprise for companies when they refinance existing debts, and so improve credit quality.
Not all investors are getting in the party mood, however. Data compiled by S&P Global Market Intelligence show that corporate-credit short positions (bets on prices falling) have grown by 25% over the past year, to $336bn. Meanwhile, businesses are rushing to take advantage while they can, with debt issuance surging as borrowers seek to lock in attractive rates. Analysts expected $15bn-20bn of new issues in the week leading up to Thanksgiving, three to four times the usual volume. How many will prove to be turkeys?
