The Worrisome Trend In Junk Bond Issuance

by: Cullen Roche

There's been a good deal of concern about the valuations in the junk bond market of late. Howard Marks and Jeff Gundlach have already expressed concerns over junk bond prices (see here for details) and it's clear from the historical spreads that this is indeed an unusual environment.

There is little doubt that the Fed's QE programs have resulted in a "chase for yield" which has led to this environment. Those who claim the Fed doesn't contribute to market instabilities clearly don't interact in markets very often….

The worrisome part of the junk bond market is not the valuations as much as the sheer magnitude of the issuance. As John Hussman notes this week we are starting to see some worrisome quantity of issuance (via John Hussman):

On the subject of junk debt, in the first two quarters of 2014, European high yield bond issuance outstripped U.S. issuance for the first time in history, with 77% of the total represented by Greece, Ireland, Italy, Portugal, and Spain. This issuance has been enabled by the "reach for yield" provoked by zero interest rate policy. The discomfort of investors with zero interest rates allows weak borrowers - in the words of the Financial Times - "to harness strong investor demand." Meanwhile, Bloomberg reports that pension funds, squeezed for sources of safe return, have been abandoning their investment grade policies to invest in higher yielding junk bonds. Rather than thinking in terms of valuation and risk, they are focused on the carry they hope to earn because the default environment seems "benign" at the moment. This is just the housing bubble replicated in a different class of securities. It will end badly.

I don't know if I'd go so far as to compare this to the housing bubble. After all, mortgage debt is 75% of consumer debt and has an especially unique place in the economy. But the issuance of high risk corporate debt appears to be an increasingly worrisome trend that the Fed won't be able to control as the cycle progresses. After all, if they tighten policy they risk lighting the match that would trigger the fire that causes high yield bonds to become a real economic problem (as a weak economy leads to defaults).

And so they are forced to keep rates and monetary policy accommodative while also keeping prices "higher than they otherwise would be". It all works out fine in theory, but the cycle always turns at some point. And when it does the Fed will bail out the usual suspects and pretend to have saved the neighborhood they helped burn down.