The money manager’s job is supposed to be straightforward: Take people’s cash and put it to work. The more money that comes in, the bigger the manager’s paycheck.
So why would two of the country’s largest fund managers tell would-be investors in junk bonds—the common name for bonds issued by companies with the lowest credit ratings—to go away?
The short answer is that it’s for their own good. The market for junk bonds, the pros say, has become so popular that it’s dangerous.
Thanks largely to the unsteady economy, interest rates on U.S. government bonds have fallen to record lows. And individual investors remain leery of the stock market.
Desperate for better returns, they’re sinking billions into higher-paying bonds backed by businesses with bad credit scores. Those deeply indebted companies have borrowed a record amount from investors and are increasingly using the money in ways that could strain their ability to pay it back.
Earlier this year, two mutual fund giants, T. Rowe Price and Vanguard, began turning down people hoping to invest in funds that buy junk bonds. Both said they were running out of worthwhile places to put customer money.
“It’s getting harder and harder to find places to invest,” says Michael Gitlin, director of fixed-income at T. Rowe Price. He says investors are getting paid record-low interest rates for taking on much more risk.
Consider the numbers:
- Junk-bond sales in the U.S. snapped the single-year record in October and have kept climbing. Sales for the year totaled $324 billion as of Nov. 28, according to Dealogic, a data provider. In the three years leading up to the 2008 financial crisis, a time marked by easy lending, companies with junk credit ratings sold an average of $144 billion each year.
- Companies are lining up to sell bonds because borrowing rates have never been lower. The typical company rated “speculative-grade,” one of the polite names for junk, pays 6.6 percent to borrow in the bond market. The average over the past decade was 9.2 percent, according to T. Rowe Price research.
- Demand for junk has remained strong. Individual investors, people saving for retirement or building a nest egg, have put $28 billion into U.S. junk bond funds this year while pulling $85 billion from U.S. stock funds, according to Morningstar.
- Over the past 10 years, individual investors have dropped $96 billion into the junk bond market, according to a Vanguard research paper. The bulk of it, 77 percent, was deposited in the past three years.
All it will take, Phillips and others say, is a dust-up in Washington over avoiding the tax hikes and government spending cuts known as the “fiscal cliff” to cause a sharp drop in the stock market. If that happens, the junk-bond market will likely take a fall.
With the presidential election over, market focus will turn to mediocre corporate earnings, an uncertain climate in Washington and the possibility of recession lurking ahead. (Read More: Why US Economy May Be Headed for Another Recession)
“Despite the favorable liquidity conditions and the demand for yield, we expect to see U.S. high yield names begin to underperform investment grade credit and US [Treasurys] as we head into 2013,” Thomas Tzitzouris, fixed income strategist at Strategas, said in a recent analysis of the group.
Strategas cut high yield to an underweight position in its recommended portfolio, basing the move on several factors. (Read More: Fixed-income market outlook.)
The firm sees a near-certainty of a recession as 2013 begins and believes investors need to prepare for a “fiscal cliff shock” related to government negotiations over how to avoid the series of tax increases and spending cuts set to take place Jan. 1.
Investors are “putting a back-up generator in the basement of a flood-prone area” by piling into longer-dated fixed-income securities with yields at about record lows, according to BlackRock Inc. (BLK)’s Jeffrey Rosenberg.
Investors that have fled stocks after the biggest financial crisis since the Great Depression “have been flocking to fixed income, and that’s worked, but interest rates are at historic low levels and so there’s a lot more danger in areas of the market where they think there’s a lot of safety,” Rosenberg, the chief investment strategist for fixed income at the world’s biggest asset manager, said in a Bloomberg Television interview with Betty Liu.
Investors hungry for yield are starting to scrape the bottom of the barrel.
Sales of U.S. company bonds rated triple-C by Standard & Poor’s, one of the last rating categories before default, hit $5.9 billion in September, according to data provider Dealogic. That made it the second-busiest month on record, after June 2007, and a post-crisis high.
The rush of ultra-low-quality debt comes as central bankers hold rates at rock bottom, with the aim of pushing investors into riskier, higher-yielding assets to stimulate economic growth. Demand for higher-yielding bonds has encouraged speculative-grade companies to borrow cheaply and for the most part enabled them to refinance existing debt maturing in 2014 and later.
Why the boom in junk bonds will burst and the dire consequences of the fallout for pension funds, local and state governments, and individual investors.
That deceptively simple line drawing on this page tracing the yield on junk bonds from 1998 to the present is, in fact, a stark and telling depiction of the subject of her musings — the bubble in junk bonds. It may not rate as a startling discovery — we have droned on from time to time about the budding bubble in junk, as have numerous others, as well as Stephanie herself — but her latest warnings are notably trenchant and all the more urgent in a world of incredibly low interest rates in which the hunt for yield has become an almost maniacal pursuit.
She cites the torrent of dollars pouring into high-yield-bond funds (junk bonds’ proper moniker) a whopping $43 billion so far this year, some 130% more than the existing full-year record, spurred by a glaring lack of decent alternatives. That lack, Stephanie observes acidly, scarcely constitutes a sensible long-term investment strategy and, the perils of sublimating fundamental concerns to a desire for yield, she’s firmly convinced, are sure to end in tears.
Bloomberg: Traders are upping their bets that the junk-bond selloff continues.
Investors are placing a record volume of bearish bets on junk bonds by shorting State Street Corp.’s exchange-traded fund that owns the notes as the debt loses value for the first month since May.
The volume of borrowed shares of the SPDR Barclays High Yield Bond ETF surged to 22.8 million on Nov. 16, about three times the average during the past year and up from 9.75 million shares a month ago, according to Markit Group Ltd. In a short sale, traders sell borrowed stock in a bet they can profit from price declines.
Investors are using ETFs, which typically allow individuals to speculate on securities without directly owning them, to hedge against further declines in junk bonds as the notes lose 0.7 percent this month, according to Bank of America Merrill Lynch index data. Speculative-grade debt funds reported $1.3 billion of redemptions last week, the biggest withdrawal since June, as concern mounts that the U.S. economy won’t grow quickly enough to support the most-indebted corporate balance sheets.
The Financial Lexicon: High-yield bond spreads have risen 60 basis points in the last month. How much higher can they go ?
Over the past month, high-yield corporate bond spreads have quietly risen 60 basis points off their 2012 low of 524 basis points. The following table shows the spread over Treasuries of the “BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread” since the October 18, 2012 low.
|High-Yield Spread(basis points)|