Covenant quality tumbled to 4.56 in May from 3.8 the previous month, according to Moody's, which rates on a one-to-five scale, with five being the worst. It was the largest single-month change on record.
Marty Fridson calls the plunge "a discouraging setback," but notes it could be due to the large amount of higher-rated junk issued in May - those high-yield bonds with stronger ratings tend to have easier covenants than the really junky stuff.
More from Fridson: "The long-run trend of covenant quality since the 2011 inception of the Moody’s series has been dismayingly negative. That tendency has been abetted by the investment banks, which compete for underwriting mandates partly on the basis of devising new loopholes."
Jeff Gundlach gets a lot of attention for his calls - many of which prove eerily prescient - but it's only fair to point out the occasional boner.
"Do not buy a junk bond index fund," he said at what proved to be the bottom of the selloff in high yield in January. "You're going to end up selling it at a loss as they get more and more populated with distressed energy and mining issues."
The total return of HYG in the four months since is 12.55%.
It's curious given the low default rate - just 2.83% in 2015 vs. the long-term average of 3.33%. Usually low default rates mean high recovery rates.
Fridson: "This outcome has generated anxiety among high-yield portfolio managers. Has some structural change taken place, they wonder, such that investors should expect lower average recovery rates over the remainder of the present credit cycle than in the past?"
Answering his own question, Fridson says special conditions associated with the energy crash along with one large, non-energy defaulter are behind the low recovery rate. For now, there's no clear evidence that recoveries on a more general basis are lower than they should be.
Moody's now expects global speculative-grade defaults to hit 5% by the end of November - that's up from 4.6% forecast one month ago, and 3.8% prior to that.
Perhaps looking in the rearview mirror as it drives, the agency takes note of the oil price slump as continuing to put upward pressure on defaults. Being at least a tiny bit forward-looking, Moody's at least mentions tighter credit spreads of late as perhaps suggesting the default rate could taper.
Of 46 defaults recorded in the year's first four months, 18 were in oil and gas, and 9 in metals and mining.
In the U.S. the default rate for metals and mining companies is expected to rise to 11.5%; and for oil and gas to 10.3%.
After a tough start to the year, junk bonds are on a tear - now having returned 6% YTD, with the overall yield sliding to just 6.9% from 10% earlier in 2016.
The bigger action has been in the junkiest of the junk sectors, with paper rated CCC having returned a full 9% YTD, including that of low-grade energy companies having returned 10%.
The term "Goldilocks" has re-entered the lexicon, with bulls saying we've got an economy strong enough to prevent defaults, but not so strong as to warrant tighter monetary policy. The oil price crash? Yesterday's news, they say.
Marty Fridson says high-yield has returned to "extreme overvaluation" territory. Jeff Gundlach, however, calls junk bonds still somewhat cheap, though noting the high proportion of the lowest-quality paper being issued of late.
The ratio of high-yield ETF volume to actual bond trading hit a record high of 42% on Dec. 11, according to Fitch. This even as high-yield ETF assets were just $34B vs. $1.2T in high-yield bonds (as of the end of February).
The increase in ETF volumes is happening during a period of declining dealer inventories of high-yield corporate paper.
A slowdown in U.S. growth could be the catalyst that pricks the bubble, they say as speculative credits find it even more expensive to borrow.
It could be happening now as high-yield issuance is lower by 53% this year, and the lowest-grade paper (CCC ratings) yields 15.2% even after the big rally of the past couple of months.
If they're correct, the two say spreads to Treasurys could more than double to 16.4%. "Investors were herded into lower-quality credit risk for a yield pick-up of a couple hundred basis points ... But the fundamental problem is that the default risk is exponential, not linear in these securities."
There's typically very little relationship between the returns on non-energy junk bonds and the price of oil, but the correlation between the two has soared of late to an all-time high of nearly 0.65 (with 1.00 being an exact match), according to Deutsche Bank.
Non-energy junk bonds make up about 88% of the high-yield market, according to BAML, which says the tight linkage today means investors aren't paying enough attention to growing risks among junk issuers. Among them: As the price of oil rises, junk bond prices improve even as costs high-yield issuers like manufacturers and transportation companies.
With another week of inflows ($2.01B last week), U.S. high-yield funds have now recorded five straight weeks of inflows since what may or may not be a major bottom on Feb. 11. Over just the last four weeks, funds have drawn in $11.52B, the largest-ever one-month gain for that asset class, according to BAML.
BAML's Michael Contoupolos, however, pulls out the yellow flag: "The fundamental backdrop has not changed and defaults are in fact increasing ... These inflows are an over-reaction to transitory tailwinds ... The recent rally has limited staying power."
Investor poured $5.8B into high-yield bond funds in the week ending March 2, according to BAML, the largest weekly amount on record. Alongside that, government bond funds experienced their highest outflows ($2.4B) in four months.
"Complacency is creeping back in and we do not think policy makers will beat expectations," says the bank's Michael Hartnett. "Thus the risk rally is likely to peter out in coming weeks."