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Dash for trash [ClearOnMoney]
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Commentary

Dash for trash

8 May 2013 by Jim Fickett.

One of these days the credit markets will turn; the most likely trigger will be either (1) success in Japan's new program to create inflation, causing a loss of interest in Japanese Government Bonds or (2) defaults in the US corporate junk bond market.

Regarding the second option, defaults will stay low so long as “investors” continue the “search for yield” and pour more money into horrible balance sheets. But when yields go low enough, the money flow will slow, mismanaged companies will be unable to refinance, and the defaults will begin. Yields on junk debt have been dropping at a truly remarkable rate lately, so perhaps the rush to throw money down the toilet will slow soon. From the Financial Times today:

Heavy buying has pushed down the average yield on CCC-rated bonds to 6.77 per cent from 10.13 per cent a year ago, significantly cutting the compensation that investors receive for the higher risk of default.

And CCC-rated companies – deep in junk territory – are taking advantage of the demand by raising cheap debt in near-record quantities.

“’It’s a frenzy out there with these high yield bonds,” said Jason Brady, a portfolio manager at Thornburg Investment Management. “We’ve been spending a lot of time trying to sort through an avalanche of new issuance which is, by and large, of terrible quality.” …

In the space of five months, the average yield on US junk debt has tumbled more than 100 basis points from above 6 per cent. Average yields stood at 4.97 per cent on Wednesday, according to Barclays.

The average annual default rate on CCC debt is about 9% (Junk bond bubble), but this average hides high cyclicality. In recessions the CCC default rate can rise to more like 40% (High-yield investors could get burned soon). So accepting 6.77% yield is quite extraordinary.

Obviously those who were willing to ignore the risks in junk have made out quite well lately. However even ignoring the risk, the high returns in junk cannot go on as they have been. We've gone from 10.13% to 6.77% on CCC in a year. If that pace goes on for another year, CCC will have yields similar to Treasuries. The frenzy is unlikely to go so far.