With Federal Reserve keeping short-term interest rates near
zero, investors say they have no choice but to seek ever-riskier securities to
generate any type of return. That means almost any borrower is able to sell
bonds with few questions asked.
The value of bonds tracked by the Bank of America
Merrill Lynch Global High Yield Index has soared to more than $2 trillion.
It took 12 years for the index, started at the end of 1997, to reach $1
trillion, and only four years to add another trillion. More than $350 billion
of high-yield debt has been sold this year, putting 2014 on track to top last
year’s record $477 billion.
So far, investors have been rewarded: Junk-bond investors
have enjoyed a total return of 157 percent, better than the 122 percent for the
MSCI All Country World Index of Stocks, since the depths of the 2008 financial
crisis as measured by Bank of America Merrill Lynch indexes.
Investors are eager for high-yield debt that borrowers
increasingly are dictating their own terms. Moody’s Covenant Quality
Index for junk bonds, which tracks the strength of investor protections in
high-yield bond contracts, is at almost its weakest level since it was created
in 2011. For the first time, more than half of the junk-rated loans made in the
U.S. are “covenant-light,” meaning they lack typical lender safeguards such as
limits on the amount of debt a borrower can amass relative to its earnings.
Investors are relaxed because central banks are doing so
much to support the market. The Fed has injected more than $3 trillion into the
global economy through its bond purchase programs. Central banks’ largesse
means that borrowers who otherwise would have defaulted have been able to
refinance and extend maturities, giving lenders few reasons to worry. The
global junk-rated corporate default rate fell to 2.2 percent in June. The
company sees the rate finishing the year at 2 percent, well below the
historical average of 4.7 percent.
While keeping rates low, central bankers have started to say
they’re worried that investors are too complacent, increasing chances for
future market instability. Junk-rated borrowers have $737 billion of debt due
in the next five years, peaking in 2018. That prospect hasn’t deterred
investors, who keep paying higher prices for risky debt, driving yields down
(yields fall as prices rise). Since peaking at 23.2 percent at the end of 2008
during the financial crisis, average junk-bond yields tumbled to a record-low
5.6 percent last month.
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