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Irrational exuberance in high yield

July 24, 2009

It’s shouldn’t be surprising that investors are feeling giddy. The world financial system didn’t collapse, big banks are making hand over fist and stock markets, well, stock markets have been on fire (today excluded). But a V-shape economic recovery in the U.S? Really?

Well that’s what the riskiest portion of the high-yield corporate debt market is pricing in. Bank of America analysts say they’ve never seen anything quite like the rebound in CCC-rated corporate debt – the lowest of the low when it comes to credit quality.  The CCC index is nearly at 70 points, 10 points above its normal level seen in 1990-91 and 2001-02 and well above the sub-40 trough seen at the peak of the credit crisis.

The only times when CCCs breached the 70pt level to the upside was when both of those cycles were officially over. Unless this credit cycle is fully in the rearview mirror, this level has no historical precedence.

The fact that higher-rated corporate debt isn’t seeing the same kind of rosy outlook should serve as a warning sign. The reach for yield is back with a vengeance as some investors have been forced to jump into the far reaches of the junk bond market to boost returns. But they’re taking on enormous risk.

Applying rosy default assumptions, the analysts found that CCCs are expected to only return an average of 1% over the next five years. And under more reasonable assumptions, CCC returns turn bright red.

Buyer beware indeed.

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