How Junk Bonds Can Look Attractive and Scary at the Same Time
High-yield bonds aren’t offering high yields. The distortion is in underlying interest rates
In the world of ultralow rates, investors are being forced to wrestle with some head-scratching conundrums. For instance: how can high-yield corporate bonds simultaneously look historically expensive, yet also attractive?
The paradox is clear in Europe. On an absolute yield-to-worst basis—making the assumption that issuers take advantage of low yields to redeem bonds early, reducing the potential return to investors—euro-denominated junk bonds currently yield just over 3.5%, according to Bank of America Merrill Lynch indexes. That is very close to the lowest on record. High-yield bonds aren’t living up to their name.
But the relative-value picture, measured by the yield spread over government bonds, is very different. The spread on the euro high-yield bond index is currently around 4 percentage points. That is far above the low of 1.8 percentage points recorded in 2007 before the financial crisis hit, even though the yield then was north of 6%. Today’s spread looks relatively attractive in a world where income is a scarce commodity. It also gives support to those who think corporate bonds have further to rally.
In Europe, the quality of the high-yield market has actually improved. Before the crisis more than half of the debt issued was from companies rated single-B and lower; now it is double-B-rated companies that make up the lion’s share of the market. The European speculative-grade default rate stood at 2.6% in July, according to Moody’s, well below the global rate of 4.7% and the U.S. rate of 5.5%.
The thing that has really changed in this equation, of course, is underlying rates. In mid-2007, the five-year German government bond yielded around 4.5%; propelled by loose monetary policy, it now yields minus 0.5%.
But even if spreads aren’t too tight, low underlying yields have a way of distorting valuations. First, zero or negative yields are a low bar to beat. Anything with a positive yield begins to look attractive. Even gold has become newly shiny, its lack of cash flows no longer a flaw.
Second, investors are having to take much more risk for reduced total returns. European junk bonds now offer less yield than a triple-A-rated five-year German government bond did before the crisis. While the fall in yields has delivered windfall gains to investors, it has also reduced the prospects for future returns. Absolute yields matter—especially for assets that bear real credit risk, where they help compensate for defaults that will occur.
And third, even though interest rates are expected to remain low, the worrying bit of the equation looks to be the risk-free rate, a key building block for valuations of assets such as corporate bonds and equities. The relative value pyramid is resting on unsound foundations.