In theory, investors demand higher returns for bearing higher risks. However, things are not so clear in the distorted world of corporate credit.
America’s businesses have never been so indebted, and yet investors in high yield bonds have rarely been so complacent about the risks they are taking.
High yield or ‘junk’ bonds are those with sub-investment grade credit scores, rated especially vulnerable to default. Historically, investors have demanded a premium (known as a spread) to hold junk bonds over investment grade debt, to compensate for this risk.
The spread investors demand tends to increase significantly as credit market and economic risks build – especially when the total level of corporate debt is climbing quickly, as can be seen in the chart above, in several cycles before 2008-2009. Counterintuitively, over the last decade the high yield spread has fallen, even as debt has climbed rapidly.
Whilst the quantity of debt has been increasing, its quality has been eroding: average credit ratings in both investment grade and junk categories have declined along with interest cover ratios (a measure of debt affordability) in recent years.1
In other words, risks have increased substantially, but the return demanded has fallen.
At one level, this is unsurprising. The same artificially low interest rates which have encouraged companies to issue debt in unprecedented amounts have driven income-starved investors to buy the same debt.
Much of this debt has been used to fund share buy-backs, whereby companies acquire their own stock. US companies have now become the largest acquirers of their own shares in recent years due to these buy-backs.
Yet as the Federal Reserve continues to hike interest rates and the economic cycle grows longer in the tooth, the risks to corporate credit also rise.
If investors begin to demand more compensation for the risks they are taking, interest expense will rise and earnings will fall, unless growth remains robust indefinitely. The implication is clear: corporate America, credit investors and stock markets more broadly, could all be in for a shock.
At Ruffer, we believe that investors will in time demand greater returns – most likely during a market crisis – at which point we will see the high yield spread blow out. We own protections which should profit from such a move because, as we all know, after the party comes the hangover!
Chart source: Bloomberg, Thomson Reuters Datastream. High yield spread defined as Barclays Capital US Corporate High Yield ‘yield to worst’ minus US 10 year Treasury yield.