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High noon for high yield

17 Dec 2015 By Neil Unmack

Junk bond investors will find safe havens lacking in 2016. Defaulting energy and commodity firms made junk debt a money loser over the past year. It’s likely to get worse as the Federal Reserve raises interest rates. Bets that Europe will be protected by central bank money-printing may prove wrong-headed.

By the start of December, the return on easy-to-trade U.S. junk-rated debt, including interest payments, was 5 percent in the red, according to Barclays’ indices. Most of the pain came from the commodities sector, as falling prices made debt harder to service for firms like Essar Steel Algoma. That helped trigger the mid-December collapse of a $789 million distressed debt mutual fund managed by Third Avenue.

Such woes are set to spread. Rate increases are usually accompanied by a growing economy and rising corporate earnings. But global growth is weak: emerging markets are sputtering and even the U.S. economy will grow at just 2.5 percent, according to Citigroup. That’s nearly half the rate in previous rate cycles like 1994 or 1999. Companies also have taken advantage of ultra-cheap money: even those rated above BB+ have the highest debt as a multiple of EBITDA since 2002, according to Morgan Stanley.

U.S. junk bond investors are already getting picky. Sales of bonds rated CCC halved in November compared with a year ago to 9.5 percent of the total, according to Fitch Ratings. Third Avenue’s plight may persuade them to pull money from other funds. Over half of the capital that flowed into high-yield mutual funds since 2009 has yet to exit, according to EPFR data.

Buyers are pricing in a default rate of 4.8 percent, once the troubled commodity and energy sectors are excluded, according to Lehmann Livian Fridson Advisors. That’s only marginally above the historical average.

The European Central Bank is still buying bonds, of course. But the region won’t be immune to rising rates elsewhere. That will come as a shock to traders punting on diverging markets: there is a 3.5 percentage point difference in yield between CCC-rated European and U.S. debt, up from 40 basis points at the start of the year. High yield is heading for a battering.

This view is a Breakingviews prediction for 2016. Click here to see more predictions.


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