Large investors are rushing into the riskiest corporate bonds, frustrated by low interest rates on safer investments and convinced that even companies with shaky finances are in little danger of default. Colin Barr joins MoneyBeat. Photo: Getty Images.
Large investors are rushing into the riskiest corporate bonds, frustrated by low interest rates on safer investments and convinced that even companies with shaky finances are in little danger of default.
One sign of that rush: Investors have been buying up corporate bonds with a triple-C rating, a grade that analysts and investors consider highly speculative.
That buying is driving up prices on those bonds and pushing down their yields, which this month fell to 8.187% on a closely watched Bank of America Merrill Lynch index—the lowest level on record. Yields fall when prices rise.
Demand for those and other bonds rated below investment grade—so-called junk bonds—is helping fuel corporate merger-and-acquisition activity. Ortho-Clinical Diagnostics Inc. on May 8 sold $1.3 billion of junk notes to yield 6.625%, in part to back Carlyle Group LP’s acquisition of Ortho-Clinical from Johnson & Johnson. The sale was increased from $1.15 billion.
Last month, French cable company Numericable Group SA raised $10.9 billion in junk bonds to help fund parent company Altice SA ‘s acquisition of French telecom company SFR—a record sale that nearly doubled the previous biggest junk-bond sale.
The demand for low-rated debt is raising concerns that investors are stockpiling future risk. Kathleen Gaffney, portfolio manager of the $700 million Eaton Vance Bond Fund, says recent buyers could be hit when rates eventually rise—which would drive down bond prices.
The yield on 10-year U.S. government bonds hit 2.53% Monday, down from 3% at the end of 2013 and well below expectations of most analysts and investors.
“At some point it’s not sustainable,” she says.
The demand for riskier debt comes as many stock-fund managers have been selling shares of riskier, fast-growing young companies in favor of safer bets, such as dividend-paying utilities and telecommunications companies.
This embrace of risky bonds and the retreat from risky stocks reflect a world where interest rates are staying much lower, much longer than most had expected, some investors say. “What we’re seeing is the continued search for yield,” says Matthew Rubin, director of investment strategy at Neuberger Berman, which oversees $247 billion.
The decline in Treasury yields reflects investor expectations that U.S. growth won’t pick up this year as quickly as anticipated, following an icy winter and a series of soft housing and output data.
Those yields reflect damped expectations for a Federal Reserve interest-rate boost—a prospect that eases fears among some investors that rising rates could trigger debt defaults by low-rated companies. They’re taking comfort in the expectation that the economy, while muddling along, isn’t likely to fall into a recession that would threaten widespread defaults.
The low-rate environment, says Ford O’Neil, manager of the $14.5 billion Fidelity Total Bond fund, “is forcing folks into riskier strategies in which they feel they will be more richly compensated.”
The Total Bond fund has been holding less of its portfolio in U.S. Treasurys and government-backed mortgage bonds. In their place, the fund has more corporate debt—both investment grade and junk—along with more non-U.S. debt, including in emerging markets.
The 12-month trailing default rate from low-rated corporate borrowers edged up to 1.7% in April, from a six-year low of 1.57% in March, according to Standard & Poor’s Ratings Services.
Also driving junk-bond price gains: Issuance of U.S. Treasury, high-grade corporate and junk bonds has declined from a year earlier, raising the attractiveness of new bonds. Combined investment-grade and junk-bond sales are down marginally from prior-year levels, at $639 billion, according to Dealogic, but remain above the pace of any other previous year.
The yield gap between junk bonds and U.S. government debt—a measure of the premium investors receive for taking on the risk of junk bonds—has narrowed. On triple-C-rated debt, that gap recently hit 6.97 percentage points, the lowest since November 2007. The all-time low of 4.14 percentage points was hit earlier that year.
In the bond market, the search for yield has been a powerful dynamic for years. That is the case even as the Fed has been pulling back on its purchases of U.S. Treasurys and mortgage-backed securities to keep rates low.
The Barclays U.S. corporate high-yield bond index is up 4.2% this year, while U.S. investment-grade corporate bonds have gained 5.19%. Higher-grade bonds have enjoyed a bigger tailwind from rising Treasury prices because investment-grade bonds tend to be longer-term.
Stock investors, too, are searching out income in an economy where earnings growth remains hard to come by. After a rally last year led by young technology and drug-development firms that were perceived to have outsize growth prospects, stock investors have headed for safer ground this year.
The S&P 500 utilities index is up 8.6% this year, while the S&P Biotechnology Select Industry Index is down 2.5% and the Russell 2000 index of smaller-company shares has retreated 7.8% from its high.
One gainer has been real-estate investment trusts, which pay out 90% of taxable income to shareholders. The SPDR Dow Jones REIT exchange traded fund is up 16% in 2014. “REITs and utilities are just crushing it,” says Jonathan Golub, chief U.S. market strategist at RBC Capital Markets. “These stocks act as a bond substitute.'”
Traders say these stocks have also benefited as hedge funds seek shelter from the carnage among once-hot technology and biotechnology shares. Cybersecurity firm FireEye Inc. has tumbled 70% since the March 5 high of the Nasdaq Composite Index, while software firm Splunk Inc. is off 52% and short-messaging service Twitter Inc. is down 41%.
Not all investors are convinced that junk bonds and defensive stocks can continue rallying.
Neuberger’s Mr. Rubin expects U.S. economic growth to pick up as the year goes on, which will lead investors to return to so-called cyclical stocks that can benefit from stepped-up business activity.
The recent gains, he says, “are likely to be short-to-intermediate term trends, as opposed to real long term.”—Dan Strumpf contributed to this article.