Junk bonds offering handsome returns

Specifically, high-yield debt issues offered average returns to maturity of 7.24% as of Sept. 30. That compares to a benchmark yield of 1.44% for the 10-year Government of Canada bond. The spread that counts, given that the junk market is mostly in the U.S., is high-yield bonds’ average spread of 508 basis points (bps) over the 10-year U.S. Treasury bond, which pays 2.10% to maturity.

“There is a lot of risk in junk, of course. But the current high-yield bond default rate is just 2% for all issues, old and new,” says Barry Allan, president and CEO of Marret Asset Management Inc. in Toronto. Usually, the spread matches the default rate, he explains. When the spread is 425 bps over treasuries, the default rate is about 4.25% of outstanding issues.

So, with a 2% default rate and a 511-bps bonus for betting on junk, the cost of entry into the high-yield bond market is cheap; or, if you want to look at it from the point of return, the potential gain vs default loss is well above average.

Junk bonds, excluding those issued by energy firms, have been doing well. Defaults are concentrated in energy companies, especially upstream drillers and undercapitalized oilfield services firms. About 15% of the Merrill Lynch master II high-yield index (the junk market’s benchmark) is energy debt, for which yields average 11.1%.

The risk in junk is concentrated on upstream producers, among which defaults on bonds rated B2 or lower – what Moody’s calls “highly speculative” – are expected to rise to 7.4% of issues outstanding by March 2016 from 2.7% this past summer.

Moreover, the forecast of 7.4% is based optimistically on the price of a barrel of oil returning to US$70-US$75 by summer of 2016. The implication is that the default rate could get worse if oil prices drop further.

Clients willing to take on junk bonds need to parse their risks carefully. By calculation, you could infer that a 4.89% default rate on outstanding junk bonds has been priced in, a higher rate than the 2% default rate in September and more than the 2.7% default rate of this past summer.

A huge recovery in energy prices would change those numbers, but that recovery is unlikely to happen. Moreover, oil-price speculators have massive reserves they’re withholding from the market and China is reported to be hoarding oil. If those reserves are poured into the market, a major price tumble would be inevitable.

So far, investors have not turned tail on junk. Yet, they might do so. In 2011, when S&P took away the U.S. Treasury’s AAA credit rating, central banks around the world were on the verge of launching quantitative easing programs to reflate credit markets.

In turn, debt markets swelled with cheap cash. Upstream oil companies, especially in the U.S., borrowed heavily to fund shale-oil exploration. Oil and gas drillers issued US$213 billion of junk bonds in the ensuing four years, increasing the share of energy firms’ debt in the junk market to 13% in 2015 from 9.4% in 2005.

Now, the chickens have come home to roost. With the price of oil threatening to drop lower and interest rates to rise higher, the fate of energy-related junk is clear.

What may be the catalyst in energy-related junk defaults is the seasonal closing of refiners in October, when crude oil will back up into storage. The price of fresh oil will drop as low as US$20 a barrel, predicts a Goldman Sachs Group Inc. report dated Sept. 17.

Default risk can be diversified by buying many issues, but junk bonds typically are traded lightly. Dealers tend not to maintain inventory; the issues are traded over the counter; and an individual investor has a hard time buying retail-sized lots of $10,000-$50,000.

Matters are getting tougher in the junk bond trade. Major Wall Street dealers, including Goldman Sachs and Deutsche Bank AB, have chosen to stop trading the U.S.-dollar priced debt of Canadian issuers. That, in turn, means bonds from issuers such as Quebecor Inc. and Air Canada may be harder to trade, thus widening the spreads.

Reduced liquidity can work to the advantage of speculators, creating larger profit margins. For non-institutional investors, not so. For example, an Air Canada 7.625% issue due Oct. 1, 2019, and rated BB was recently priced at $107 to yield 4.17% to maturity. That’s 350 bps over a comparable four-year Canada bond, which yields 0.61% to maturity.

Thus, you and your clients should not be misled by the high intrinsic risk in buying into weak bonds. Says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto: “If oil holds below US$50 [a barrel] for another year, defaults will rise. You don’t want to be overweighted in energy bonds now.”

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