U.S. Junk-Bond Storm: Picking Through the Wreckage
The high-yield bond selloff is more nuanced than it at first appears
The U.S. high-yield bond market has come to represent the sum of all fears for investors. A poisonous combination of misallocated capital, restricted liquidity and declining commodities is hammering returns. But under the hood, the state of the market is more nuanced.
December has made an already rough year much worse. At the end of November, U.S. “junk” bonds had lost 2% this year, according to Barclays index data; by Monday’s close the market was down 5.8%.
The energy and metals and mining sectors unsurprisingly are bearing the brunt, down 21.6% and 25.4% respectively. Other sectors are doing much better by comparison. Consumer cyclical bonds are still in positive territory, albeit only just, up 0.1%; noncyclical consumer bonds are down just 0.3%. Unfortunately for the high-yield market as a whole, energy and mining companies carry a big weight: excluding financial-sector companies from the index, they account for 23% of the debt outstanding.
The swing in oil prices to a seven-year low and the decline in other commodities is driving divergence in the market. It is pushing up risk premiums across the board; that will hit both stronger and weaker companies. But it is also affecting the distribution of risk. Lower oil and commodity prices should be helpful for consumers, although the effect may take time to be felt. That is why consumer-facing companies are holding up well. The high-yield market as a whole isn’t in meltdown.
Indeed, the market has done what it has always done: provide capital to riskier companies and then sort the winners from the losers. The extended period of ultralow interest rates encouraged both companies to lever up and investors to take risk; the inevitable result is that capital has been misallocated. The biggest damage is in the riskiest credits: while double-B rated bonds have lost 2.3%, single-B bonds are down 6.3% and triple-C 13%.
The problem layered on top of that, however, is more complex: constraints around liquidity, in part due to regulation aimed at making the financial system safer, in part due to fund structures with an inbuilt liquidity mismatch. The risk is that funds facing pressure may be tempted to sell what is easiest—which is likely to be better-performing bonds—rather than the market laggards they really need to get rid of. For other investors, that offers a potential opportunity.
The twists and turns of the high-yield market now need to be watched closely. If higher-rated, stronger companies from sectors outside the oil and commodities complex were to face difficulty in raising cash, then the risk is of a wider credit crunch. At least not many companies will be trying to do so in the rest of December. January will be the real test.