High-yield bonds: reality of fixed-income investing sets in

Do not call it high yield but, for now, higher yield. Easy money and a strong economy pushed junk bond yields below four per cent, levels where the most creditworthy companies in the world borrowed not so long ago.

But in recent weeks reality has set in. In November, total returns on junk bond indices fell one per cent, a rare monthly drop observed in the last two years. These implied yields have jumped as the Fed is expected to begin tightening monetary policy over rising inflation just as fears of another coronavirus variant grip the global economy.

The thirst for yield has since the financial crisis sent terms for risky debt to once-unfathomable places. Despite the turmoil, the overall junk bond yield remains a modest 4.75 per cent. Still, this may be the long-anticipated moment bondholders finally ask to be properly compensated for risk.

Companies and their investment bankers have been watching the charts. This year has seen record high-yield issuance, with more than $400bn raised. That broke last year’s record, according to figures from Dealogic.

A majority of the issuance has been by companies refinancing existing obligations to lock in lower rates as well as push out maturity dates. Junk bond issuance driven by leveraged buyout transactions has also accelerated and observers note that mega transactions — those above $10bn — are increasingly possible with private equity funds having trillions in dry powder.

What remains to be seen is if the worries about an economic contraction now embedded in yields and prices arrive in the form of defaults which have remained muted for now. For investors holding junk debt, paper capital gains losses can still be mitigated by coupon payments and ultimately principal repayment.

One measure to watch beyond just yields are spreads to risk-free Treasuries. The high-yield spread measured by ICE BofA has sharply widened in recent weeks as well. Buying a fixed-income instrument at ever-decreasing yields has reached its limits.

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