Collapsing yields on risky US debt test investors’ limits

The additional premium investors are paid for buying the debt of the worst-rated companies in the US has fallen to its lowest level in seven years, raising warnings that the brightening outlook for the American economy is leading to excessive risk taking.

The premium, or “spread”, above benchmark government bond yields on triple C-rated US corporate bonds, which sit on the precipice of defaulting, has fallen to just above 6.4 percentage points, according to data from Ice Data Services. The spread has been lower on only two occasions: in 2014, just before a collapse in oil prices roiled the debt of energy companies, and in the run-up to the 2008 financial crisis. 

It is a dramatic recovery from the near 20 points on offer in the depths of the coronavirus-induced crisis, highlighting the scale of the recovery brought about by vaccines and historic fiscal and monetary stimulus.

Investors are playing an important role in the recovery. They are soaking up the colossal scale of fundraising that has taken place during the pandemic, even for triple C-rated companies, giving those businesses more time and stability to outlast the crisis.

At some point the reach for yield reaches its limit, and we think it’s here

But the upbeat demand means investors are now compensated for taking on elevated risk, lending money to increasingly debt-dependent companies at shrinking borrowing rates, in bets that could easily unravel if the economic recovery disappoints.

“I think there is a fair amount of complacency in credit right now,” said Nichole Hammond, a portfolio manager at Angel Oak Capital. “We don’t think we are being compensated to invest in the riskier issuers.”

Many of the worst-performing bonds have already defaulted in the past year, dropping out of Ice’s index and leaving the overall quality of the bonds left behind in better shape. 

S&P Global Ratings’ measure of distress in the market, which tracks issuers with bond spreads above 10 per cent, has fallen to its lowest level since October 2007. Bank of America’s own credit stress indicator is at its lowest level since 2014. 

However, analysts and investors warn that the potential for catastrophe is masked by accommodative monetary and fiscal policy.

Over the next 12 months if corporate earnings rise an estimated 25 per cent, Bank of America analysts still expect debt compared to earnings before interest, taxes, depreciation and amortisation for triple C issuers to be at a multiple of 14 times, in line with the worst metrics seen in 2009. At the same time, cash flowing into high yield funds and issuance of new debt from the lowest-rated companies is starting to ebb. 

The analysts conclude that the allure of higher spreads in return for higher risk in a low interest rate world is waning as the returns on offer have been dragged down in recent months.

BofA analysts said they believed fund managers were now “struggling” to justify taking on risky bets with such low returns. “At some point the reach for yield reaches its limit, and we think it’s here,” they said.