Are Junk Bonds Signaling a Swing in the Capital Markets?

| About: SPDR Barclays (JNK)

Junk bonds, also known as high yield debt, issued by those companies in less than sound financial condition, have always accounted for a large portion of the credit pie. During the recent turmoil, debt was hard to sell. Even companies with the prestigious AAA credit ratings from the ratings agencies often paid a substantial amount to shore up their balance sheet. If the healthiest companies found it hard, one could only imagine how hard of a job it was for those seeking to sell their “junk” to shore up their finances. The junk bond market literally came to a halt as the collapse of the nation’s large financial institutions destroyed liquidity for the better part of 2008. However, April 2009 has signaled a better time for debt and especially such high yield. With investors willing to take on such risk, is this a sign of a sustained swing in the capital markets?

Signs of Relief

The one thing I can tell you about the markets is to do your homework and never base a judgment off one piece of good news. I imagine that life is probably much better for those that needed to issue high yield debt, as signs of relief from both the debt and equity markets are enabling companies to improve (or reinforce) their financial position. Ownership values, as determined by the stock market, are making it easier for companies to issue debt across the board. This link between equity and debt is very important because any increase in share prices signal improving business conditions which should allow sub investment grade entities to service new debt with improved cash flows. Do not get me wrong, things are not what they used to be by any means, but there are signs of improvement from the economy and investors should assuage any concerns of a prolonged extreme bear market.

A large part of this relief comes from a slow down in the macroeconomic downturn we have been experiencing since late 2007. GDP and unemployment are falling at slower rates while consumer confidence is returning. The markets are also more confident in our financial system as the LIBOR has fallen from its highs last year to a little under 100 bps on the 3 month LIBOR. This improvement in liquidity has helped companies finance themselves, although at higher rates, but at terms that satisfy investors while keeping costs within appropriate bounds. No one can deny that the various government facilities have helped bond issues by the large financial institutions as many of them have been backed by the government. This basically gives you the solid AAA credit rating with a yield that is significantly higher than the meager yields on a US Treasury of the same maturity. All of these factors have really improved investor confidence, which is a major driver in the market. If the investor is not confident in a company or a security, they will not bite. It seems the tides have turned and investors are once again hungry for some risk.

Return of Investor Confidence

Junk bonds are some of the more riskier securities one could buy. Historically, the market has been strong for such issuances, but these issuances were hurt like everything else in the credit crunch. When investors are deciding to return to these riskier securities, the most risky of all debt, it is a sign that confidence is returning.

Last week saw one of the largest junk bond offerings get filled as the paper was bid up, a sign that should really help us feel better about the markets. If these less healthy companies are attractive now, the slow turn in the credit markets and the bull run taking place in equities should be here to stay. The overall sentiment on the economy is improving and with the Fed suggesting a 2010 recovery, it seems that the credit and equity markets will be leading this. It is good to see an increased appetite for risk, after all, high risk leads to a high potential reward.

I am not saying that that you should dip into the risky bonds like many institutional investors are, but to simply understand that this indicates a pretty certain recovery. Although it is still expensive on a historical basis for these corporations, it signals that investors feel that they are being compensated for the risk they assume. The days of cheap debt are long gone as models and risk behaviors are adjusting and corporations meet the high yield expectations of the bond markets.

It appears that risk is now back in play and that the capital markets should benefit from it as the economy improves and companies understand the new kind of investor that has surfaced from the credit crisis. Keep an eye on the markets, do not fear, but learn and adapt to the dynamics of post credit crunch investing.

- Santosh Sankar

Disclosure: None.

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