Article 6.1 Triple C bond sales hit record high
By Vivianne Rodrigues
Financial Times November 15, 2013
Global borrowers with weaker credit quality are taking advantage of investors’ relentless search for higher yields to sell a record amount of bonds so far in 2013.
Intelsat, the world’s largest satellite-services company, the US casino owner Caesars Entertainment and the luxury chain Neiman Marcus have been among the low-rated borrowers to have sold a combined $38.1bn debt this year, according to Dealogic. That amount surpassed the previous record of $37bn for the whole of 2012. Bonds with the lowest possible credit ratings have soared in popularity with investors, who have been diverted from top tier government and corporate debt where central banks are suppressing interest rates.Heavy buying has pushed down the average yield on triple C rated bonds to 7.75% from 9.80% a year ago, significantly cutting the compensation that investors receive for the higher risk of default.
Michael Collins, a senior investment officer for Prudential Fixed Income, said the risk-return equation involving very low rated bonds is now ‘asymmetric’.
‘Investors are not being fully compensated for holding some of these bonds.’
The demand for yield has become the big driver of investor behaviour as they downplay high valuations for junk bonds.
The gamble for investors is that as long as the Fed keeps on trying to suppress interest rates, and as long as corporate default rates - currently 2.3% per year - remain below historical norms, the prospect of losses is limited.
But the risks are twofold: a general rise in rates could cause investors to abandon risky overpriced assets, while weaker economic growth or falling lending standards could cause a spike in defaults.
‘Easy money has pushed investors to take more and more risk,’ said Sabur Moini, a high-yield bond portfolio manager at Payden & Rygel.
‘A severe downturn in the US economy and a freeze in the high-yield market is a potential big risk. But investors can make the argument that, from a perspective on margins and cash flow, the average company is healthier now than it was five years ago.’
Total returns on this tier of the junk bond market have been higher than nearly all fixed-income asset classes this year and now stand at 11.6%, according to Barclays data.
That compares with returns of 5.9% on junk bonds as a whole and a negative return of 2.2% on investment grade corporate debt.
While top tier corporate bonds are rated on the basis of an investor being repaid their principle with interest, the assumption behind junk debt is that the company could at some point default on its obligations.
Source: Rodrigues, V. (2013) Triple C bond sales hit record high, Financial Times, 15 November.
One of the major attractions of this form of finance for the investor is that it often comes with equity warrants or share options attached, which can be used to obtain shares in the firm - this is known as an equity kicker. These may be triggered by an event taking place, such as the firm joining the stock market. They give the right but not the obligation to buy shares at a fixed price in the future. If this is at, say, £1 per share and the firm performs well, resulting in the share rising to, say, £5, the warrant or option holders can make high returns.
Bonds with high-risk and high-return characteristics may well have started as apparently safe investments but have now become more risky (fallen angels) - see Article 6.2 for an example - or they may be bonds issued specifically to provide higher-risk financial instruments for investors who are looking for a higher return and are willing to accept the accompanying higher risk (original-issue high-yield bonds). This latter type began its rise to prominence in the US in the 1980s and is now a market with more than $130 billion issued per year. The rise of the US junk bond market meant that no business was safe from the threat of takeover, however large - see Box 6.1 on Michael Milken.