Junk Bonds Are Heavily Overbought Amid Tight Credit Noose

By Eric Roseman

One of the greatest asset reversals has occurred over the last three months with stunning velocity…

Junk bonds, or high-yield bonds, have seen their yields crash since peaking in early March from 17% to just 9.3% now. The index has gained 17% in 2009 – better than U.S. stocks and other segments of risky credit.

Junk Bonds Bounce Back Hard and Fast

According to Moody’s, the U.S. speculative-grade default rate on junk bonds surged to 9.2% in April, compared to 8% in March and just 2% a year earlier. Moody’s, however, predicts the default rate will peak at 14.8% in the fourth quarter…before declining to 10.4% twelve months from now.

Overall, 89 of the 112 defaults year-to-date were by North American issuers while European companies accounted for another 11 defaults.

With all due respect, these are the same guys (Moody’s) that gave high credit ratings to mortgage insurers and a host of banks and investment banks with little or no tangible assets ahead of the credit crash in late 2007.

Personally, I’m not so sure the default rate will peak in the fourth quarter. In fact, I’m betting the opposite will occur…

Historically, the default rate on junk bonds has peaked at around 10-15% in previous post-WW II recessions. But this isn’t a normal recession; we’re still trying to climb out of the worst credit environment since the 1930s. This will not be a “normal” post-war recovery because credit expansion remains anemic.

More importantly, if credit to the best-rated companies remains challenging…then imagine what lies ahead for junk bond rated companies…

This group has a tsunami of refinancing coming due from now until 2014 to the tune of $950 billion dollars. If the strongest credits are still struggling to raise capital and certainly paying a premium over short-term lending rates to secure that credit, then it only seems logical that junk bond financing will struggle.

In other words; there’s an avalanche of defaults coming our way in the high-yield sector – assuming the economy isn’t in a new bull market. And historically, you never buy junk bonds when the default rate is still rising; still, as default rates have climbed markedly recently junk bond prices have soared. Something is wrong with this picture.

Bear market rallies are always convincing.

The worst of the lot get swept away with the short-term trend making an ugly duckling look like a golden goose. This is still a very challenging macro credit environment whereby financing and refinancing trends have not returned to pre-crisis levels.

Yes, the government has done a good job of masking the damage and insolvency of the banking system -- including fudging the accounting rules -- but now the real economy is next on the chopping block. This will be a much harder magic trick to follow. We’re nowhere near the end of this bear market in credit.

In the recent issue of my Accelerated Income I just issued a recommendation to short or bet against junk bonds – up 29% since the March low.

Moody’s is wrong; the default rate will probably peak north of 20% in this cycle…just like it did more than 75 years ago.

Comments

[Old Trader]

If one agrees with the premise that much of the recent run up in equities was in lower quality issues, it would make sense that "hot money" would start looking elsewhere, as equity valuations started looking like less of a bargain. I'm actually somewhat surprised at the numbers on defaults, ytd, mentioned in the article. I'm referring to the fact that European issuers only accounted for 11 out of 112. Look for that number/percentage to go up dramatically, since it appears the EU is in even worse shape than the US.

2009 Jun 16 10:18 AM

[Mad Hedge Fund Trader]

Short term for sure. It looks like the worm has finally turned. Hedge funds that rushed headlong into piling on new risk positions as recently as last Friday are now unwinding them today just as fast. All last week the smart money was selling to the late comers, newbies, and wanabees. The Viagra is starting to wear off. It’s time to take short term trading profits on crude (USO), commodities (DJP), all stocks (SPX), emerging markets (EEM), short Treasury bonds (TBT), all currencies (FXE), and junk bonds (JNK, HYG). I love all these things long term, but suffer from a short term tolerance for paid. When the best case scenario is sideways, I’m outa there. Look for decent bounces in risk reducing positions like the dollar ($USD), short dated Treasury securities (CSJ), and defensive sectors like utilities (IDU). It has been obvious to me that all of the good, long term holds were rolling over on shrinking volumes right at 50 or 200 day moving averages, since last month (see “Sell in May and Go Away” at www.madhedgefundtrader...).

2009 Jun 16 02:47 PM

[Larry House]

I think you are right. Junk bonds mirror equities (usually), so the run up is understandable. You are probably right about a higher default rate than Moody's predicts. They tend to be conservative, but it is just a guessing game to pick a number. I do think junk bonds are topping out, just like stocks, and are due a correction. There will be another better buying opportunity when the default rate does jump and scares everyone out of junk bonds. That is the time to buy.

2009 Jun 16 03:48 PM

[BGRT]

"if credit to the best-rated companies remains challenging…then imagine what lies ahead for junk bond rated companies…" -- Not exactly true. If you're talking about Citi, yes, but real blue chips like IBM? Their spreads are very low vs equal duration treasuries.

2009 Jun 16 07:06 PM