“Junk bonds are exposing the excesses of the credit boom,” says Richard Beales on Breakingviews. “So, at least, it seems.” The trailing 12-month default rate among speculative-grade (riskier) bonds hit 8.3% in April, from 1.7% a year ago.
Recovery rates – what the investor gets back – are dropping; recent auctions to settle credit default swaps (derivatives contracts that pay out when a borrower defaults) suggest investors expect to get back around 15% of face value on the latest round of defaults. At less than half the average recovery rate, “that sounds frightening”.
But it’s not out of line with previous downturns (recoveries were about 12% in 1981). So a “gloomy outlook may be more than adequately priced in”.
Or maybe not, says Michael Lewitt of Harch Capital Management; certainly not among the most distressed and lowest-ranking debt. Recent big defaults have been paying “fly-speck recoveries” of 2%-4%, with the “lion’s share of losses” coming among bonds issued to fund private-equity leveraged buyouts.
Investing in distressed bonds is “extremely treacherous in the current environment”. Fundamental research on individual bonds will do better than “broad-based bets” on the market.
Consequently, the recent rally in junk debt – the Merrill Lynch US High Yield Master II Index benchmark has return 16.5% since the start of April – is overdone. It has been driven by belief in “green shoots”, not fundamentals, says Willem Sels of Dresdner Kleinwort. This enthusiasm will fade amid “disappointment about the speed and amplitude of the recovery”.