“Is the party over for the junk-bond market?” asks Taron Wade on Breakingviews.com. Until now, the demand for junk bonds (high-yield, riskier debt) has seemed insatiable: markets have been so happy to swallow up this year’s record-sized debt issues in Europe that the firms involved are paying record-low rates. Junk-bond funds “have been on a tear”, says Michael Hudson in The Wall Street Journal. “So far this year, they’re out-performing stocks and most other bond funds and are on track to produce an average annual return of more than 6%.”
So the private-equity firms that are buying Dutch media company VNU got a major shock two weeks ago as they struggled to shift a $1.67bn junk-bond issue; they ended up paying significantly higher rates than hoped and had to build in extra protection for investors.
But it should be little surprise if buyers are finally getting more demanding.
Since new high-yield debt isn’t currently very high-yielding, it looks unattractive in an environment where interest rates are rising, says Wade. And there’s also the small matter of risk, says Hudson.
Bond prices are affected by default rates, which are still extremely low at present – around 1.57% against a historic average of almost 5%, according to ratings agency S&P. But this may change if the economy slows; S&P is forecasting that defaults could be back up to 3.6% by mid-2007.
If that happens, markets will demand higher yields on new issues and depress the price of existing lower-yielding debt.
That will be costly for firms issuing debt – and for those high-flying junk-bond funds.