Junk Bonds' High-Wire Act
Buyers of risky corporate bonds are starting 2017 in a precarious position.
They're coming off the best year of returns since 2009, with a 17.5 percent gain last year that was fueled largely by the rebounding oil prices. And many traders are betting that the good times will just keep on rolling. This is anything but certain.
It won’t take much of a negative surprise to inflict pain on these bond buyers. That’s because investors are accepting a shrinking amount of yield to lend money to companies that are closest to default. They’re now receiving the smallest amount of extra yield over benchmark rates to own speculative-grade bonds since September 2014.
This is significant, especially at a time when many investors think that key rates on U.S. government debt will continue to rise. Junk bonds, which have traditionally been cushioned from rising yields because of their extra cushion of spread, don't have much of that cushion left.
Meanwhile, the Federal Reserve has already raised overnight borrowing costs twice from their all-time lows and are planning several more increases this year. Big foreign investors are becoming less committed buyers of Treasuries. Inflation is rising globally.
While U.S. government debt yields may not spike, it's hard to see them plunging to their recent lows without a recession. And in that case, economic downturns aren't typically kind to the most-leveraged companies.
Of course, a recession is far from many investors minds right now; they're generally counting on robust U.S. economic growth, largely because of big spending programs anticipated under President-elect Donald Trump. But that’s not certain.
Many analysts think the market is in the later stages of the credit cycle, meaning that credit quality is expected to deteriorate in the near future. A combination of poorer credit quality and rising Treasury yields could prove to be an unpleasant brew. Restructuring specialists have already been homing in on retail, health care and other industries that are pocked with failing companies.
This is not the first warning about riskier corporate credit. Many analysts and financial journalists have commented about potential pain among junk debt. Some have come to fruition, at least in the short term. Others haven't. In general, despite the drastic swoon in energy and all-related debt in 2015, high-yield bonds have been an amazingly reliable bet. They've delivered average annual gains of more than 13 percent since the end of 2008, better than a broad index of global stocks or government debt.
So it can be easy to dismiss doomsday talk about riskier corporate credit as hyperbole and wishful thinking for a time when bonds had much higher yields -- say 13 percent, the average in 2001, rather than the current average of less than 6 percent. As Karl Wallenda used to say, "Life is on the wire. The rest is just waiting."
Still, it's important to recognize that at this point it's easier for this debt to lose value than it is to keep gaining. It only gets more precarious the farther you get out on the wire.
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