Junk Bond Default Risk Increases with Spreads Near All-Time Lows & Riskiest Bonds Do Best

By the Curmudgeon

Moody’s: Default Risk Increases for U.S. Companies:

Bloomberg reported on Thursday that the number of U.S. companies at the greatest risk of defaulting is at an 11-month high. That’s largely due to continued uncertainty around President Donald Trump’s global trade war and how it has worsened credit conditions, according to a Moody’s Ratings report. In the second quarter, 16 companies were added to the list of businesses with the highest default risk. That “likely to default” group now stands at 241 companies.

The number of companies that defaulted also increased last quarter compared to the prior period. Most were technology companies, though Moody’s expects firms in the consumer products sector to see more defaults in the coming months. More than four times as many companies moved off the highly speculative list due to a default than companies that moved off the list via an upgrade.

“With U.S. tariffs and trade uncertainty unsettling global commerce in April, credit conditions have deteriorated” since the beginning of the year, Moody’s analysts wrote. The group includes U.S. non-financial corporates with a Moody’s rating at or below the highly speculative Caa1 rung or with a higher B3 rating but are at risk of a downgrade.

Moody’s wrote that they anticipate the trend of out-of-court debt restructurings to persist throughout the year, given that private equity-owned companies make up a significant portion of their distressed debt population.

Distressed debt exchanges remain the leading type of defaults, according to Moody’s. Companies typically propose distressed exchanges — a kind of restructuring agreement — to avoid bankruptcy, improve liquidity, reduce liabilities and manage upcoming debt maturities, the ratings firm said.

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Junk Bond Credit Spreads Near All-Time Low:

It’s incredibly astonishing that despite the increased default risk and huge economic uncertainty, the option-adjusted credit spread [1.] of the lowest-rated BBB bond category was near an all-time low this week at 1.01 percentage points. That’s clearly depicted in this chart:

A graph of a line

AI-generated content may be incorrect.

Note 1. The option-adjusted credit spread measures how much higher the junk bond yield is compared to a risk-free Treasury equivalent duration bond.

At such ultra-low credit spreads, investors are taking on very high risk with hardly any reward. Yet they don’t seem to care?

Unlike the U.S. Treasury backed by the Fed, companies can’t print dollars to repay debt and their bonds. Liquidity is also an issue. Junk bonds can’t be bought and sold as easily due to large bid/ask spreads or NO BIDS AT ALL.

The BBB spread briefly hit 1.5 points around “Liberation Day” on April 3^rd. When Covid-19 arrived, the spread went from 1.3 to 4.9 percentage points before the Fed bought corporate bonds to calm markets. During the financial crisis it topped 8 points.

Those junk bond meltdowns seem like ancient history, but there are few measures left to prevent a repeat credit crisis. Post-financial crisis regulations limit the ability of bank trading desks to absorb large volumes of bonds, even as bond mutual funds have grown substantially.

The private credit market, now valued at $2 trillion, has become accessible to individual investors and is even being incorporated into mainstream target-date funds. Much of this private credit is packaged into Collateralized Loan Obligations (CLOs), which are then sold in tranches, some of which are now held by yield-hungry ETF investors. This increased exposure to complex and potentially illiquid debt structures across a broader range of investors could pose new challenges if credit market conditions deteriorate.

Finally, already humongous U.S. Treasury debt auctions are likely to increase (due to huge budget deficits). That could “crowd out” high yield corporate bond buyers in a recession.

Risk-On into Riskiest Junk Bonds:

U.S. junk bond investors are piling into the riskiest bonds even as JP Morgan CEO Jamie Dimon and other prominent market watchers are cautioning that valuations on credit are severely stretched. Dimon said this week that credit spreads are “a little unnaturally low,” a month after saying that if he were a fund manager, he wouldn’t be buying credit. “Bond King” Jeff Gundlach, CEO of DoubleLine Capital, said last month that his firm has its lowest ever allocation to high-yield bonds because valuations don’t reflect the risk of default.

Investors seem oblivious to risk as CCC rated bonds have gained 0.75% this month through Thursday, outpacing all other ratings tiers, including investment-grade.

In sharp contrast, the highest-rated junk bonds, those in the BB tier, have turned in the worst performance among speculative-grade debt, implying that investors are trading out of the less risky junk bonds and into the riskier fixed income securities paying the highest yield.

The gap between BB high yield notes and BBB investment-grade bond spreads on Thursday was just 0.75% (75 basis points), well below the average for the last decade of about 1.2%, meaning investors can buy BBB bonds from larger companies and get a spread not terribly lower than BB debt.

U.S. Treasury debt (the highest quality bond with zero default risk) has done the worst. The total month to date

return for the iShares 20+ Year Treasury Bond ETF (TLT) is -1.41%, according to MacroMicro. This includes both capital gains and dividend returns. Specifically, the capital loss is -1.78%, while the dividend return is 0.37%.

Closing Quotes - Investors Take on More Risk:

“As investors have become more comfortable, they’ve begun to reach for risk,” said Robert Tipp, chief investment strategist at PGIM Fixed Income in an interview.

“The equities market is telling you that recession probability is not elevated right now,” said Bill Zox, a portfolio manager at Brandywine Global Investment Management. “So that all seems to be consistent with, the dedicated high-yield investor going from BBs to Bs or if an investor wants to move up in quality, why not go to BBBs rather than BBs.”

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Wishing you good health, success and good luck. Till next time…

The Curmudgeon
ajwdct@gmail.com

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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever-changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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