In one corner of the financial markets, a 1980s-style revival is in full swing. Junk bonds are seeing their greatest days since the time when everyone wore braces and listened to the Human League. Not since the disgraced 1980s financier Michael Milken first popularised high-yield debt has junk received so much attention in the markets.
On one level that is understandable. With interest rates close to zero, investors are desperate to put their money into an asset that offers some kind of meaningful yield. But it is also a clear sign of a market going crazy. The rally in junk bonds is driven almost entirely by central banks, rather than by any rational reappraisal of the value of high-yield debt. And when markets become irrational, there is always trouble ahead.
Despite their rather unfortunate name, junk bonds are not necessarily rubbish fit only for the garbage can. They are rather more politely known as ‘high-yield’ bonds, and they are typically issued by companies that are rated BB-minus by Standard & Poor’s or one of the other ratings agencies. And over the past year, they’ve been more like gold than rubbish. European corporate junk bonds have returned 16% this year, including reinvested interest, according to Merrill Lynch figures. Sales have almost doubled. Companies in Europe issued €57 billion of junk-rated bonds this year, almost double the amount raised in the same period in 2009, according to Bloomberg. They have done significantly better than European government bonds, which have returned about 8% in the past year, itself a fairly decent rate of return.
It is much the same story in the US. Companies there issued a record number of non-investment-grade bonds in 2010 – $200bn so far this year, compared with $106bn in the same period of 2009. September was the busiest month on record for junk-bond sales in America. And junk bonds have returned 11% this year in the US, compared with 7% for the S&P 500 index. On both sides of the Atlantic, investors have been better off buying high-yield bonds this year than just about any other asset, apart from some of the emerging markets. Why is this?
Default rates have turned out to be much lower than expected. As the world slumped into the worst recession since World War II, there were widespread fears of a wave of corporate bankruptcies.
We thought dozens of big names would go bust, as they did during the deep industrial recession of the 1980s. It didn’t happen. In this country, Woolworths disappeared from the high street. In America, General Motors had to be rescued by the government. But in general, the corporate sector has come through the worst of the downturn in good shape.
That might be because governments have pumped money into the economy (though there is no real evidence that stimulus programmes have had any real effect). Or, more plausibly, it might be because labour markets have become so much more flexible in the last two decades, and production so much leaner, that it was far easier for companies to adjust wages and output rather than go out of business, as they might have done in the past.
The result is that corporate bonds, even with fairly dismal credit ratings, are a lot safer than we used to believe. If they managed to come through this recession, the risks of default are actually fairly low. That makes the bonds worth a lot more.
Remember that sovereign debt hasn’t been looking in great shape either. The main alternative to junk bonds are triple-A rated bonds issued by governments. But ever since Greece blew up so spectacularly at the start of the year, investors have been rethinking whether government bonds are as safe as they once thought. It is generally assumed that Greece will default on its debts at some point. Other countries may well follow.
Against that backdrop, most high-yield corporate bonds look a far better bet. They don’t have anything like the same kind of liabilities as most governments. And they have far better future income streams. That is another reason for repricing much of what has traditionally been regarded as junk.
Yet there are reasons to be wary. Yes they might be more attractive than they once were, but in reality, the main driver behind the junk bond rally has been the central banks. Near-zero interest rates have now become an accepted fact of life in the US, Europe and here in Britain. Rates have been held at two-century lows for a year and half now.
Pretty soon most of us will have forgotten that money in the bank ever yielded any kind of return. Most junk bonds pay out 7%-plus a year. In this environment, that is pretty generous. It is hardly a surprise that investors have been piling in. But that doesn’t mean that risk has been abolished.
In short, junk bonds are soaring in price because central banks have rigged the market. So lots of bonds will be issued by companies that can’t really afford them. Many investors will pile into assets that aren’t suitable for their portfolio.
In all probability, the market will carry on rising for some time. But while there are some solid reasons for the rally in junk bonds, it is also a market that has become disconnected from reality – and that is always a scary prospect for investors.