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Junk bond bubble [ClearOnMoney]
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Commentary

Junk bond bubble

15 Jan 2013 by Jim Fickett.

Junk bonds rated CCC have an annual default rate of about 9% and are currently paying 8% interest. Since clearly there is no value in such a purchase, everyone is just hoping to get out before everyone else. Dumb.

Yesterday the Financial Times pointed out that the yield on CCC bonds, the lowest-rated of all debt, has fallen from 11% to 8% in just the last year:

The biggest gains in the junk-bond market have been registered in its lowest-rated corner – triple-C debt, which yields an average of 8.2 per cent, down from 11.5 per cent in one year. …

The total return for US junk bonds was 15 per cent last year, spurring such large bond managers as Pimco and BlackRock to warn that investors were not being properly compensated for the risks they were taking.

On the other hand, one study on default rates, described in a 2007 Forbes article suggests defaults for CCC are in the neighborhood of 9%/year:

A recent study of defaults of all below-investment-grade issues from 1998 to 2003 was done by Martin Fridson. It was recorded in Leverage World, his weekly newsletter on the high-yield market. He breaks down the 3,065 bonds issued in those six years by the ratings at time of issuance, as well as by underwriter, in order to test how good an indicator ratings are and which underwriters had the best track record.

The results showed the following average annual default rates: BB: 2.42%; B: 5.81%; CCC: 8.91%. Compare those default rates to the current average yields for these securities: BB: 6.85%; B: 7.71%; CCC: 9.48%.

It's clear that both B and CCC issues no longer have enough protection built into their yields to warrant consideration, which is why we have been warning investors to stay away.

Note the similarity between the numbers in 2007, just before the crash, and today.

When investors buy junk bonds today they buy them because they “must find some yield” or because they went up last year, not because any analysis says they represent solid value. You can argue about whether that is a bubble or not, but you cannot argue that it is not pure speculation.