Junk-Bond Rally Hides Some Cracks

Investors are becoming more selective about their high-yield borrowers.

To the investors who plowed all their money into the lowest-rated bonds at the end of last year: Congratulations. You won the jackpot, with the best returns on such debt since 2009.

To the company with a troubled balance sheet that's hoping to borrow money this year: Good luck. Investors just aren't throwing their money into any junk-rated company anymore.

An example of this can be found in U.S. Xpress Enterprises, which opted to scrap a $320 million debt offering late Wednesday, according to Bloomberg News's Sridhar Natarajan and Michelle F. Davis. The problem? Investors weren't ready to pile into a trucking company at a difficult time for the industry unless it paid them big time. The trucker balked.

While this junk-bond deal was the first one pulled from the market in two months, it helps highlight this year's rather odd dynamic in the $1.4 trillion U.S. junk-bond market. The lowest-rated bonds are posting a spectacular rally of 12.5 percent so far this year, better than U.S. stocks and government bonds, but a growing number of companies are restructuring their balance sheets, getting downgraded and defaulting. That ultimately will put a lid on those dazzling returns.

This is the conundrum facing both central bankers and economists. It is becoming more difficult for some borrowers to raise more money despite the central bank-fueled stampede into riskier securities. This means that even as investors funnel loads of cash into riskier assets, their money isn't aimed at supporting struggling businesses.

In one sense, this is the way it should be. It's nice to know that investors aren't just lending indiscriminately. There should be a level of prudence when evaluating creditworthy borrowers. The drawback is that this dynamic will lead to higher default rates and may ultimately dent overall returns in broad indexed strategies.

Corporate credit quality has already deteriorated. The trailing 12-month U.S. speculative-grade default rate has already climbed to about 5.4 percent from 2.1 percent a year ago, according to Moody's Investors Service data.

More Defaults

The U.S. default rate has started picking up, largely because of distress among commodity companies

Source: Moody's Investors Service

Most of the trouble has stemmed from the commodities sectors, which were battered in the wake of last year's price swoon in oil and metals. Energy companies, which are failing at an accelerating pace, have sold the smallest proportion of this year's new high-yield bonds in more than a decade, data compiled by Bloomberg show.

Running on Empty

Investors have all but stopped lending to junk-rated energy companies after oil's price swoon

Source: Bloomberg

But the worries expand beyond just oil and gas. The chances of a U.S. recession have increased because of weak corporate earnings since 2014, UBS analysts Stephen Caprio and Matthew Mish wrote in a July 14 report.

As more companies run into trouble, they'll have a harder time paying back outstanding debt, which will most likely hurt returns for broad high-yield bond strategies in the longer run. That will eventually put a ceiling on how much prices can rise.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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