A $1 Trillion Junk Pile May Need 25% Yield to Be a Buy, UBS Says

  • Selloff still leaves riskiest corporate bonds too expensive
  • S&P expects defaults to spike amid global economic headwinds

Even after the riskiest junk bonds plunged 9 percent this year, they’ll need to get much cheaper before investors feel comfortable stepping in to buy the $1 trillion of stressed or distressed credit in high yield, according to UBS AG.

Yields would need to rise to 20 percent to 25 percent to lure investors into even the lowest rungs of junk debt outside of the commodities sector, UBS Securities credit strategists led by Matthew Mish wrote in a note Thursday. The debt is currently yielding around 15 percent, according to data compiled by Bloomberg.

"In short, we’re not there yet," Mish said.

Fears that credit risk is rising, global growth is slowing and declining commodity prices have triggered losses across financial markets. That’s forced many hedge funds, mutual funds and traditional institutional investors to sell good assets as well as bad assets in order to meet redemption requests or cover losses.

Outflows Continue

Credit underperformance prompted investors to pull money from the asset class for the fourth consecutive month in January. Funds ended with net outflows of $5.6 billion, Wells Fargo & Co. data show.

"Capital is wounded and illiquidity is complicating an exit," Mish said. The universe of stressed or distressed credit with refinancing needs by 2020 includes bonds rated CCC and below, or debt trading below 70 cents on the dollar or at spreads of more than 10 percent, Mish said.

Standard & Poor’s said Thursday that company defaults will probably spike faster this year than it previously forecast. Global economic and financial "headwinds" that have manifested themselves since the second half of 2015 have encouraged investors to put their money in safer assets, which has increased the likelihood of defaults, wrote Diane Vazza, managing director and head of global fixed income research at S&P.

Defaults Forecast

Defaults by companies graded BB+ or lower by S&P will rise to 3.9 percent by December, a percentage point higher than their current levels. As recently as last week, S&P had been calling for the default rate to increase to 3.3 percent by September. The long-term average default rate since 1981 is 4.4 percent.

Mere spread widening on credit could contribute to future defaults, S&P’s Vazza wrote. That’s what happened in the midst of the financial crisis: After spreads on speculative-grade debt widened to a five-year high in 2008, a wave of defaults followed and pushed the rate to its November 2009 peak.

UBS’s Mish cites a recent "structural shift" in the market. From 2010 to 2014, investors were putting their money into debt in response to stimulus efforts that at their peak saw the Federal Reserve buying $1 trillion annually of fixed-income securities, Mish said. Confidence grew because companies’ ability to access capital markets kept defaults low.

Back then, the euphoria was so strong that credit portfolio managers found themselves "forced" to buy whatever was available to deploy inflows that were "too robust," Mish said. They neglected fundamental credit analysis in favor of achieving yield targets and moved down the debt quality spectrum so they could achieve targets. In that environment, it was easy for companies to borrow money cheaply.

"That mirage has faded," Mish said.

Today’s picture is one of tightening monetary policy, rising defaults and excessive leverage. Now that investors are recalibrating their views on credit risk and global growth, the outlook for high-yield will depend on the market’s ability to absorb the refinancing needs of the $1 trillion junk mountain.

If it can’t, Mish said, contagion will spread.

Before it's here, it's on the Bloomberg Terminal.