Junk debt rally ignores 2010’s biggest risk

January 11, 2010

agnes crane2.jpgInvestors high on junk need to think about coming down. They have let risk premiums on high-yield investments get dangerously low. It’s good that fewer companies are failing. But high debt prices don’t leave room for 2010’s biggest financial market risk: the potential fallout when central banks withdraw from markets.

Investors in high-yield bonds typically build in a worst-case cushion. In this case, that doesn’t seem to happening. The average option-adjusted spread on high yield debt stood at 602 basis points as of Friday, according to Bank of America Merrill Lynch. Fridson Investment Advisors estimates the risk premium metric should now be at 658 basis points, based on Moody’s latest default data — though that could fall to 532 basis points by the end of the year if corporate defaults decline as expected.

In other words, investors seem already to be anticipating improvements in the overall corporate credit picture. Moody’s expects its global default rate, which hit a peak of 12.9 percent in November, to fall to 3.3 percent by year-end.

Looking ahead makes sense up to a point, but investors seem to be forgetting the X-factor between now and then: the removal of government support for markets. The Federal Reserve, for instance, is on track to hit its $1.25 trillion limit for purchases of mortgage bonds by end March, while the Bank of England expects to end its own asset purchase program next month.

It’s all part of a process of withdrawing government funds even before lifting interest rates. It’s unlikely every stage in this process will be timed to perfection. Along the way, the removal of official support is likely to dent the values of many assets, including junk debt and others like government bonds and stocks that look fully priced today.

It’s hard not to conclude that investors have got ahead of themselves in their relief that the worst is over — especially in risky debt markets where the specter of mass defaults has receded. That’s a relief, but other risks still out there now merit junk bond buyers’ full attention.

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