In recent months, evidence has increased that the high-yield bond market is under pressure. While this class of bonds rated below investment grade continue to trade near all-time highs, concerns are mounting beyond what’s normal for bonds called “junk” because they pay high interest because they have a high risk of not being repaid.
The delay in the tax plan has spurred a sharp selloff across growth-sensitive assets, with the S&P 500 heading for its worst slump since this summer. The BlackRock exchange-traded fund is at its lowest level since March.
Could the decline in the high-yield market indicate the end of the bull stock market or is this simply a correction in an overvalued asset class? I remain bullish on both high yield bonds and the stock market, primarily because our economy and corporate earnings remain strong.
In general, the prices of bonds and stocks move in opposite directions. When the economy is booming, stocks do well and investors generally sell bonds to buy stocks. When the economy slows, profits fall, stock prices decline and investors turn to the regular interest payments guaranteed by bonds. That is until investors begin to worry that a corporation faces a drastic decline in profits. Then investors will sell those bonds, driving down their price.
In recent years, an asset bubble was created when the Federal Reserve increased the money supply and lowered rates to prevent the Great Recession from becoming another Great Depression. Both stocks and bonds went up and investors chased both.
Market too expensive?
Currently, the difference between the yield on high-yield bonds relative to U.S. Treasuries is as tight as it has been since the Great Recession. This so-called spread is about 4 percent. Although the spread is tight, the fundamentals in the high-yield market remain solid, so we should not see a selloff that would cause spreads to widen by 2 to 4 percent more.
High-yield bonds’ yields tend to be correlated primarily with the economic strength of the company that issues them. Investors in a high-yield bond must understand the company’s outlook and whether it is prone to default. So an improvement in company revenues is more important to the health of a specific junk bond than is the general level of interest rates. When the stock market is doing well, companies can replace debt with equity, lessening their chance of bond default.
The main driver of the junk bond selloff is poor earnings by a few of the larger issuers of the bonds. Century Link, a heavily leveraged telecom, is down from $23 to $15. Community Health Systems and Sprint have declined because of poor earnings
Fears of dropping oil prices also have led to high-yield bonds’ decline. One-fifth of the entire high-yield market is composed of companies from this commodity space. So if oil prices decline from the current high $50s per barrel, we should expect a price decline in the high-yield market.
Brick-and-mortar retail represents only 3 percent of the junk market. The default rate in this sector now represents more than 21 percent of all defaults. According to a Financial Times article, “S&P pushes more U.S. retailers deeper into junk,” about 18 percent of U.S. retail bond ratings are in the CCC category, showing substantial bankruptcy risk. This is twice the level from the beginning of the year.
What to do now?
It is premature to liquidate high-yield bond or equity holdings. Selective paring of positions seems reasonable, especially since both have produced significant profits for those investing in them.
The high-yield market has returned 14 percent annually since the bottom of the market in 2009. The stock market has nearly tripled since March 9, 2016.
So I recommend ordering some champagne and toasting the bull market.
Originally published in the Sarasota Herald-Tribune
