During seven years of near-zero interest rates, where could an investor go to get higher returns in the bond market? High-yield, high-risk bonds (also known as junk bonds) offered a tempting alternative. Investors have been snatching up such bonds in increasing numbers over the last few years. Currently the high-yield bond market contains approximately $1.8 trillion in capital.
However, junk bonds are faltering and on the brink of melting down in some areas. One huge turning point took place recently when Third Avenue Management, a high-yield bond specialist, announced that they were liquidating and halting transactions on their once top-performing credit fund. This stops investors from redeeming approximately $1 billion in assets within that fund. If investors were not paying attention to the junk bond market before, they certainly are now.
Savvy investors have been watching the slide of junk bonds into the "distressed" category for some time now. Distressed bonds have yields that are ten percentage points (or in Wall Street parlance, 1000 basis points) over the yields of standard Treasury issues. Because of the inverse relationship between bond yields and price, that means the price (value) of issued bonds is plummeting.
Standard & Poor's regularly issues a "distress ratio" for bonds as a measure of their risk. The distress ratio is defined as the numbers of distressed junk bonds compared to the total number of junk bonds issued. That ratio crossed the 20% threshold at the end of November to register the worst reading since the financial crisis aftermath in September 2009. Distressed bonds totaled $180 billion at the end of November, spread out over 228 companies.
Consider these two points for perspective: The distress ratio does not count bonds that have already defaulted, and during the financial crisis, the distress ratio varied from 14.6% all the way up to 70%. In other words, the true state of junk bonds may be understated. We are treading in a bad direction, and it could get considerably worse before it gets better.
The default rate shows the same unpleasant steady increase as the distress rate. It has risen relatively steadily from 1.4% in July of 2014 to 2.8% at the end of November 2015.
High-yield bonds in the oil and gas sector are taking the biggest hit. The plummeting prices of oil have crushed stocks in the field, and company bonds are faring no better. The sector currently accounts for 37% of all distressed debt, with over half of the bonds in that sector trading at a distressed level.
Strangely, bond ratings have not caught up with this assessment. Chesapeake Energy, with $7.4 billion in distressed bonds and a plummeting stock price, is still rated well above junk bonds at a B rating. Only 24% of companies with distressed bonds have bond ratings that correspond to junk bonds (C to CCC). This suggests that the less attentive investor may simply consult the bond ratings and have no true idea of the risk levels that they are assuming with their bond purchase.
The lower end of the junk bond spectrum is understandably in the deepest trouble. Bonds rated CCC or lower have risen from 8% in June 2014 to 16.6%, surpassing the spike in yields caused by the euro debt crisis in late 2011.
It is possible that this could be a different form of debt bubble — instead of bad mortgages defaulting and propagating into the stock market through securitization, this debt bubble is forming on the bond side of the investment portfolio. We hope that the debt is more slowly absorbed into the system instead of forming a bubble that pops, but history tells us that the odds are against that scenario.