Maybe the Next Junk Bond Smash-Up Won’t Be That Bad

Art by Katherine Streeter

You know junk bonds, those flimsy, shaky things just waiting to be knocked over by the next recession’s wrecking ball? To some, the agonizing history of high-yield bonds in tough spells is about to be repeated, only worse this time because corporate America’s debt load is higher these days.

Still, there’s a decent chance the junk market won’t get slammed as badly as it did in the past. Despite some new and worrisome developments, high-yield might prove to be hardier during the recession of 2020, or whenever it hits, than junk was in the past—like during the financial crisis.

“There will be pain, but not panic,” said Francis Rodilosso, head of fixed-income ETF portfolio management at VanEck. “A repeat of 2008 is difficult to imagine.”

For the moment, things look far from stressed in junk land. The spread between high-yield and Treasury bonds is a mere 3.25 percentage points, down from a recent high of 8.6 in early 2016, when energy companies were suffering from a crash in oil prices (the energy sector has the most bonds below investment grade).

Bonds in general aren’t having a sterling 2018, due to rising interest rates, which shrinks prices. But thus far this year, according to Bloomberg, high-yield (up 2.5%) is leading investment grade (minus 2.35%) in performance. And the worst-rated junk tier, CCC, is doing the best of all, soaring 6%.

High-yield bond issuance has exploded in recent years, owing to low interest rates, which have enticed companies to float more debt. The same is true for investment grade. In fact, the largest amount of corporate debt nowadays is rated BB, the top tier of bonds in speculative, i.e., high-yield, territory. “Debt levels are high because interest rates have been low,” said Martin Fridson, CIO at Lehmann, Livian, Fridson Advisors, who is one of Wall Street’s foremost high-yield experts.     

The total amount of junk issued through August this year, $134 billion, is almost as much as the peak year before the financial crisis (for all of 2006, $140 billion), by the tally of the Securities Industry and Financial Markets Association. That said, this year’s issuance is 25% below 2017’s for the comparable period, as the result of competition from leveraged loans, which offer floating rates and better investor protection in a bankruptcy.

Demand remains strong for junk thanks to its tempting yields in what is, for now, still a low-yield environment. Whereas a 10-year Treasury pays 3.06% and a AA-rated corporate 3.5%, junk yields 6.2% on average, with CCC delivering 9.7%. Diamondback Energy recently received more than $2 billion in orders for its $500 million offering, permitting it to boost the size of the issue to $750 million.

All that debt on companies’ balance sheets leads critics to worry about a massive spate of defaults and credit-rating downgrades once the recession kicks in. A large chunk of high-yield is due to mature over the next three years, at what surely will be higher interest rates. Currently, the junk default rate is just 3.4%, and Moody’s expects that to improve to 2.6% by year-end.

When the economic cycle turns south, though, defaults historically have leapt to 10%. Making matters worse is the surge of covenant lite issues, where customary restrictions on corporate behavior, like taking on more debt, are missing.

What’s more, pointed out Jason Lazarus, portfolio manager at Intrepid Capital Funds, the new tax law limits corporate deductions on interest expenses to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA); prior to that, they could deduct 100% in interest payouts. “That’s not good if you’re highly leveraged,” he said.

Meanwhile, several Wall Street luminaries—ranging from Stanley Druckenmiller, formerly of Duquesne Capital, to Citadel’s Ken Griffin to DoubleLine Capital’s Jeffrey Gundlach—have voiced concern about a catastrophe looming ahead for debt-laden corporate America. “We have this massive debt problem,” Druckenmiller said a recent interview. “We tripled down on what caused the crisis,” meaning low-grade debt. Last time, it was mortgage-backed bonds.

Recessions are never pretty in the high-yield arena. When corporate revenue and earnings slide, meeting those lofty interest payments gets tougher. Stocks, whose fortunes also ride with earnings, are loosely correlated with junk bonds, although the bonds have the advantage of paying better. In that horrible year, 2008, the S&P 500 dove 37% and junk tumbled only 17%. 

What could render the ordeal a little less trying come the next recession:

Lower rates will make life easier for issuers. These produced more debt issuance, yet they also could cushion the impact on companies, said Kevin Miller, CIO of E-Valuator Funds. The interest tab high-yield issuers owe bondholders is much smaller than usual, thus easier to service if corporate income is reduced. (Nonetheless, that won’t help as much if they need to roll over their bonds amid climbing rates, he said.)

Bondholders are more sophisticated. This mainly applies to institutional and other players, such as hedge funds. They are increasingly comfortable about investing in distressed issues. “You hear defaults and that sounds terrible,” said John McClain, portfolio manager at Diamond Hill Capital Management. “But these bonds often recover.” In 2009, when the economy began to climb out of the Great Recession, high-yield catapulted to a 40% gain.

Overly restrictive rules have been softened. Previously, pensions funds and insurers had rules discouraging them from owning much junk, particularly if a bond suffered a credit-rating downgrade. Lately, those guidelines have been eased. “They now can hold through a downgrade,” McClain said. “They no longer have to be forced sellers,” which results in losses.

High-yield is more mainstream and transparent. In 2003, the bond industry adopted the trade reporting and compliance engine (TRACE), which allows investors to discover bond prices. Plus, the 2002 Sarbanes-Oxley law made corporate reporting more open and less susceptible to manipulation. With more information and confidence in the market, investors are less prone to dump fixed-income holdings amid economic troubles. The high–yield “market today is not like it was,” Fridson said.

That’s what investors are hoping as the economic cycle heads toward another dip.