Secret Leveraging of Junk Bonds Revealed in Stock Trade

If stock investors are any guide, the $1.3 trillion U.S. junk-bond market is being inflated by a growing amount of leverage being used by buyers.

Both stock and junk-bond managers tend to deploy more leverage when markets are booming, and more than ever is being used to purchase U.S. equities, based on levels of margin debt on the New York Stock Exchange, according to UBS AG analysts. That suggests junk-debt buyers are engaging in similar financing activities.

As investors use more borrowed cash, they increase the potential for bigger losses in a downturn. This trend adds to concern that six years of unprecedented Federal Reserve stimulus has produced a bubble in the junk-bond market -- and one that will be all the more painful when it eventually pops.

“Rising debt levels will be a problem going forward,” UBS analysts Stephen Caprio and Matthew Mish wrote in a report dated Oct. 2. Investors increase “leverage to meet return hurdles that are more challenging to hit as prices rise.”

Measuring leverage in the junk bond market with any kind of precision is a tricky thing. Caprio said in an interview that he doesn’t know of a direct way to do it.

Record Borrowing

Margin debt has surged to more than 2.5 percent of U.S. gross domestic product, about the highest level in data going back to the early 1990s, the UBS analysts wrote. The measure of leverage tends to be a leading indicator of relative yields on speculative-grade bonds, with a rising level of margin debt increasing the odds of future spread widening.

Investors are demanding 4.42 percentage points more than benchmark rates to own dollar-denominated high-yield bonds, compared with 5.9 percentage points on average over the past decade, Bank of America Merrill Lynch index data show.

While junk-bond yields have risen to 6.43 percent from the record low of 5.69 percent in June, strategists from Bank of America Corp. to BlackRock Inc. still recommend the debt in a world awash with easy-money policies as central bankers try to ignite global growth.

So, investors are still buying, and probably with a a growing amount of leverage. While even the UBS strategists say they don’t see the market souring soon, with high-yield default rates projected at about 2 percent for the next year, the market may be all the more fragile when it does.

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