Junk Debt Exceeds $2 Trillion in Central Bank RepressionCharles Mead and Sridhar Natarajan
It took three decades for the amount of speculative-grade debt to reach $1 trillion. It took about seven years to reach $2 trillion as investors sought relief from the financial repression brought on by near-zero interest rates.
The market for dollar-denominated junk-rated debt has expanded more than eightfold since the end of 1997 from $243 billion, according to Morgan Stanley. That compares with a quadrupling of the investment-grade market to $4.2 trillion as tracked by the Bank of America Merrill Lynch U.S. Corporate Index.
While Federal Reserve policies have pushed investors toward riskier investments to generate high yields, allowing even the neediest companies that might otherwise default to access capital markets, concern is rising that missed payments may soar when benchmark rates begin to increase. Martin Feldstein, a past president of the National Bureau of Economic Research, said last week that low rates should be allowed to rise because they’re driving investors into risky behavior.
“The growth in the market, and volume of supply is less important than quality of issuance,” Adam Richmond, a credit strategist at Morgan Stanley in New York, said in a telephone interview. “When we see a heavy volume of lower-quality deals, that’s when you need to worry a little bit.”
Borrowers from Michaels Stores Inc. to Chesapeake Energy Corp. have pushed issuance of dollar-denominated high-yield, high-risk bonds and U.S. institutional loans to $704.5 billion this year, including refinancings, compared with $466 billion in the first three quarters of 2012, according to data compiled by Bloomberg.
Greater issuance of speculative-grade debt from outside the U.S., combined with institutional money managers funneling a larger portion of funds into the market, should boost further growth, said Tim Gramatovich, the chief investment officer at Santa Barbara, California-based Peritus Asset Management LLC, which manages more than $300 million.
“I see absolutely no reason in the next 10 years that this market can’t double again,” said Gramatovich, who began his career in 1984 at Drexel Burnham Lambert Inc., the investment firm where Michael Milken helped forge the market for junk bonds.
The Fed has kept its benchmark overnight interest rate in a range of zero to 0.25 percent since December 2008, when yields on junk bonds reached a record 22.7 percent on the Bank of America Merrill Lynch U.S. High Yield Index.
With yields reaching a record low 5.98 percent in May, concern is mounting that markets for assets from farmland to junk bonds may be overheating. Yields on the debt, which have returned 124 percent since the end of 2008, ended last week at 6.86 percent.
Central bank stimulus efforts are “adding to the risks in the economy,” Feldstein, a Harvard University professor and a top economic adviser in the Reagan administration, said Aug. 23 in a Bloomberg Radio interview from the Kansas City Fed’s annual conference in Jackson Hole, Wyoming. “The pluses are very small and the risks are very big.”
The National Bureau of Economic Research, where Feldstein served as president and chief executive officer from 1977 to 1982 and from 1984 until 2008, determines the dates of business expansions and contractions.
Led by Milken, Drexel used junk-bond financing to help spawn a takeover boom culminating in Kohlberg Kravis Roberts Co.’s $26 billion purchase of RJR Nabisco Inc. in 1989. The following year, Drexel filed for bankruptcy and Milken pleaded guilty to securities fraud, serving 22 months in prison.
“When Drexel fell, people felt that the high-yield market would be dead,” Jack Malvey, the chief global markets strategist at Bank of New York Mellon Corp., said in a telephone interview. “The term we used back then was that it was a nuclear winter.”
Syndicated lending to speculative-grade companies increased with the development of a secondary market for loans in the 1990s that attracted non-bank financial firms such as pension funds and insurance companies, according to a 2004 report from the Bank for International Settlements.
Not even the worst financial crisis since the Great Depression derailed the junk market, with returns in 2009 on the Bank of America Merrill Lynch U.S. High Yield Index of 57.5 percent following losses the prior year of 26.4 percent.
Since the end of 2008, borrowers have sold $1.3 trillion of bonds rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
“If rates stabilize, even at a higher level, you will likely continue to see strong supply,” Richmond said. “If the economy is accelerating, we could see more supply” linked to mergers, leveraged-buyouts and capital expenditures rather than refinancing higher-cost obligations, he said.
Michaels, based in Irving, Texas, is undoing about four years of debt reduction with an $800 million sale of 7.5 percent notes due in five years to pay a dividend to its private-equity owners, Bloomberg data show. The debt was ranked Caa1 at Moody’s and CCC+ by S&P, ratings that indicate very high credit risk that’s currently vulnerable to nonpayment.
Chesapeake, the second-biggest U.S. natural gas producer, raised $2.3 billion in March selling senior bonds to redeem debt, Bloomberg data show. The bonds were rated Ba3 by Moody’s and BB- at S&P.
The Fed will likely begin to slow its $85 billion in monthly purchases of mortgage bonds and Treasuries next month, according to 65 percent of economists surveyed by Bloomberg from Aug. 9-13. The central bank is expected to end the program, known as quantitative easing, by June.
The world’s largest economy will expand 1.6 percent this year, accelerating to 2.7 percent in 2014 and 3 percent in 2015, according to the median estimate of 73 economists surveyed by Bloomberg. That compares with growth of 2.8 percent last year.
The 12-month trailing default rate on U.S. speculative-grade debt will increase to 3.3 percent by March from 2.5 percent a year earlier, S&P said Aug. 8 in a statement. The forecast compares with an average of 4.5 percent from 1981 through 2012.
“There will be a reduction in the growth in the high-yield market as default rates increase but that will be temporary,” said Edward Altman, a finance professor at New York University who created the Z-score formula for measuring bankruptcy risk.
While a more restrictive monetary policy from the Fed will probably crimp issuance in the short-run, the junk market is still poised to expand in a new era of rising borrowing costs, said FridsonVision LLC’s Martin Fridson.
“We’re likely to see continued growth,” said Fridson, who started his career as a corporate debt trader in 1976. “The demand for paper, which isn’t dependent on the Fed keeping rates low, will continue to be there,” and borrowers may eventually issue more unconventional securities such as payment-in-kind bonds or debt linked to commodity prices to lower their cash payments, he said.
Elsewhere in credit markets, the cost of protecting against losses on U.S. corporate bonds fell for a third day.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 0.4 basis point to a mid-price of 78.4 basis points as of 11:25 a.m. in New York, according to prices compiled by Bloomberg. Markets in London were closed for a public holiday.
The index typically falls as investor confidence improves and rises as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.
Bonds of New York-based Citigroup Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.4 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.