After five and a half years of the Federal Reserve keeping short-term interest rates near zero, investors say they have no choice but to seek ever-riskier securities to generate any type of return. That means almost any borrower is able to sell bonds with few questions asked—whether it’s a nation with a history of defaults or a corporation with an ultra-low credit rating. 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. “You can stay in overexuberant conditions for a while,” says Fred Senft Jr., director of fixed income and equity research for Key Private Bank. “But when it turns, it will turn quickly and it will turn very ugly.”
The value of bonds tracked by the Bank of America Merrill Lynch (BAC) Global High Yield Index has soared to more than $2 trillion. It took 12 years for the index, started at the end of 1997, to reach $1 trillion, and only four years to add another trillion. More than $350 billion of high-yield debt has been sold this year, putting 2014 on track to top last year’s record $477 billion.
So far, investors have been rewarded: Junk-bond investors have enjoyed a total 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 122 percent for the MSCI All Country World Index of stocks.
So eager are investors for high-yield debt that borrowers increasingly are dictating their own terms. Moody’s (MCO) Covenant Quality Index for junk bonds, which tracks the strength of investor protections in high-yield bond contracts, is at almost its weakest level since it was created in 2011. 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 safeguards such as limits on the amount of debt a borrower can amass relative to its earnings.
Investors are relaxed because central banks are doing so much to support the market. The Fed has injected more than $3 trillion into the global economy through its bond purchase programs. The European Central Bank has provided about $1 trillion of emergency loans to banks. Japan’s central bank has been buying about 7 trillion yen ($69 billion) of bonds per month through its own quantitative easing measures. Central banks’ largesse means that borrowers who otherwise would have defaulted have been able to refinance and extend maturities, giving lenders few reasons to worry. The global junk-rated corporate default rate fell to 2.2 percent in June, according to Moody’s. The company sees the rate finishing the year at 2 percent, well below the historical average of 4.7 percent.
While keeping rates low, central bankers have started to say they’re worried that investors are too complacent, increasing chances for future market instability. Fed Chair Janet Yellen said in June that she was concerned about “reach-for-yield behavior.” Bank of England Deputy Governor Charlie Bean said in May conditions were “eerily reminiscent” of the pre-crisis era (he left office last month). Bundesbank board member Andreas Dombret said in June that “we do see risks, despite the fact that the markets are calm.” 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, Moody’s said in a Feb. 4 report.
That prospect hasn’t deterred investors, who keep paying higher prices for risky debt, driving yields down (yields fall as prices rise). Since peaking at 23.2 percent at the end of 2008 during the financial crisis, average junk-bond yields tumbled to a record-low 5.6 percent last month, according to Bank of America Merrill Lynch index data. Martin Fridson of Lehmann, Livian, Fridson Advisors, who started his career as a debt trader in 1976, has rarely seen a market so unworried about defaults. “It’s about as extreme as it gets,” he says.