July 31, 2018
Below investment grade corporate debt (“junk bonds”) can be an integral component of many portfolios’ composition and performance. They command a higher risk premium, as they are issued by companies that have uncertain financials, high debt levels, and/or poor earnings. As a result, their trading prices can be extremely volatile. The FOMC’s zero interest rate policy after the crisis has indirectly caused a reach for yield by investors, often at the expense of proper due diligence of a company’s financials and macroeconomic considerations. 2019 may be setting up to be a volatile year for junk bonds.
Rising interest rates and an extremely narrow spread between junk bonds and Treasuries historically doesn’t bode well for junk’s future performance. High yield bonds (measured by ICE BofAML US Corporate B Index) currently yield around 2.75% more than 10 year notes. Historically, this support level has led to a major mean reversion to around 7.5% (see graph below). Despite little to no net earnings, many of these companies have been able to survive and thrive the past few years as a result of the FOMC’s zero interest rate policy. As the Fed hikes toward its 2019-2020 median forecast (3.1-3.4%), it will undoubtedly make short-term borrowing costs more expensive for companies who tap the high yield market.
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Corporate debt levels as a percent of gross GDP remains significantly elevated; more frighteningly, more than 50% of all investment-grade companies are rated just one notch above junk (Bloomberg, Gluskin Sheff). With each FOMC rate hike, financing costs for these ‘shaky’ companies will likely increase notably, causing a readjustment in risk premium or dramatic rise in yield. Furthermore, as the European Central Bank ends its government and corporate bond buying program in late 2018, European corporate bonds’ prices may experience significant yield increases, spilling over into the U.S. junk bond space. Investment managers with leveraged junk bond positions could exacerbate the potential rise in yields, especially relative to Treasuries, if they unwind their positions.
As 2019 approaches, investment managers should be aware of the potentially perfect storm of volatility within the corporate bond space. Global central banks are removing liquidity and as a result, financing costs for these troubled companies could increase exponentially. Speculative leverage may contribute to a major mean reversion in the high yield and 10yr note spread.
That said, those who wait patiently may be rewarded with attractive buying opportunities if current euphoria dissipates and historical mean reversion takes its course. But until that actually happens, it might be a good idea to prepare for bouts of volatility and higher junk bond yields.
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Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. May be worth less than the original cost upon redemption.
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