Challenging times await US junk bonds after banner run

When financial market parties end, the worst hangover usually resides with buyers of junk bonds.

The party lights may still be flashing for US high-yield but the music has turned more sombre after a stunning run that has produced a return of almost 180 per cent, or nearly 18 per cent on an annual basis since 2009.

Not only has the asset class thrashed the broad US bond market over that time, junk bonds have outperformed the S&P 500's total returns over the past decade. As a result, the high-yield moniker has looked increasingly inappropriate with the market's average yield now below 6 per cent. That may be up from under 5 per cent last summer against an average of almost 10 per cent since 1990.

Now the clock has started ticking on such a barnstorming run for junk.

After years of helping keep corporate default rates extraordinarily low by flooring borrowing costs, the US Federal Reserve is preparing to raise interest rates. This could hurt the ability of more indebted, riskier groups to refinance their liabilities. At the same time, a number of companies are being hurt by the oil bust and the dollar's strength.

Sherif Hamid, a high-yield portfolio manager at AllianceBernstein, argues that the US junk market still looks attractive but cautions that there is likely to be a bout of turmoil when the Fed starts lifting rates, and has been positioning his fund more cautiously.

"The question is whether the volatility proves a buying opportunity, or signals the cycle rolling over. If it's the end of the cycle we could see more significant problems," he warns.

For now, the outlook for downgrades remains low but there is the risk that the credit cycle could turn a lot faster than many currently anticipate.

"We believe that the pending rise in interest rates and borrowing costs, coupled with volatile commodity prices, a protracted strong dollar and a weak euro will likely lead to negative rating actions for some US corporate borrowers, especially speculative-grade issuers, by the end of this year," Standard & Poor's recently warned.

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US energy junk bonds aren't the only concern.

Bank of America Merrill Lynch points out that the Affordable Care Act has made healthcare the fastest-growing constituent of the high-yield market since 2009 after energy. Yields on non-investment grade healthcare bonds are now the lowest of all sectors, at just 4.7 per cent, a fact the US bank's analysts argue should cause concern.

"The search for 'quality' yield has led to a very crowded trade in the healthcare sector in our opinion," BAML's strategists wrote in a recent report. "Although at this time we are far from worried about default risk in the space, we view the mark-to-market risks as quite high."

Adding to the concerns, if the party ends abruptly, investors in junk bonds may find the exit very narrow. The illiquidity of bond markets has become an increasingly pressing topic across the financial industry, and high-yield is one of the worst-affected areas.

However, many analysts and fund managers argue that US high-yield bond market is likely to weather the coming years better than doomsayers fear. Returns may be more subdued but will probably still outpace those of safer, more highly rated debt, they argue.

In the bond market rout of 1994, when the Fed aggressively and unexpectedly lifted interest rates, high-yield bonds were dented but outperformed the wider debt market.

Moreover, for yield-starved investors there is a paucity of alternatives. On average junk bonds yield three times more than the Barclays Aggregate bond gauge's 2 per cent. Even stripping out beaten-up energy bonds the US junk index still yields 5.5 per cent.

Jim Keenen, head of credit at BlackRock, points out that Fed rate increases will only come in tandem with economic growth, and that will buttress the creditworthiness of junk-rated companies.

"We're in the latter stages of the credit cycle, so people need to be disciplined. But a rising interest rate environment tends to be good for credit," he adds.

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