Why junk bonds aren’t in a bubble

May 11, 2011, 2:25 PM UTC

Just how bubbly is the bond market, anyway?

It looks a little scary out there nowadays. High-yield bonds, for instance, are trading at low yields. The effective yield on the Merrill Lynch High-Yield Master II index — tracking bonds issued by sub-investment grade companies — dropped to 6.88% this week.

Bad news, good news?

The last time it was that low was December 2004. It is an odd-looking milestone, considering that the unemployment rate then was 5.4% — compared with a sticky-looking 9% now.

The tumbling yields, together with some risky junk-bond deals stitched together in recent months, mean that “worries of a 2005 – 2007 style overextension are creeping back into common parlance,” says Janney Capital Markets fixed income strategist Guy LeBas.

“The market is definitely priced for perfection right now,” says Scott Grzankowski, a market analyst at bond manager KDP Asset Management in Montpelier, Vt.

But does a strong junk bond rally necessarily spell bubble? LeBas and others say it is early yet for that sort of talk, as tempting as it is.

While yields are approaching their lows of the past decade, spreads to Treasury securities are well above their 2007 level (see chart, right), suggesting investors haven’t totally lost sight of risk in the chase for yield. There is time yet for that, no doubt.

And while it’s tempting to think of the low yields purely as an artifact of unbelievably loose Federal Reserve policy, there are other factors. Defaults are low, refinancing is easy and buyers – including retail investors fed up with low deposit rates, scared out of the muni market and worried about inflation down the road – are flooding into the market.

They’re betting that even at higher prices, debt issued even by less-than-pristine corporate borrowers provide a better risk-reward balance than government or higher-quality corporate bonds.

“The yields are lower, but you’re still not getting a bad return compared with investment grade bonds,” says Grzankowski.

The flow of funds – retail investors have poured about $11 billion into high-yield this year, Grzankowski says, compared with $37 billion last year – is likely to mean issuers can keep raising funds at low rates. That’s good news for companies such as satellite broadcaster Dish, chemical maker Celanese and homebuilder Shea Homes, all of which sold high-yield bonds last week.

The recent sales follow a frenetic period in the junk market. High-yield bond issuance rose 14% from a year ago in the first quarter, Fitch Ratings said last month, to $73.5 billion — the second-largest quarterly total on record, after the fourth quarter of 2010.

Fitch said the continued flow of funds into high yield is contingent on the economic outlook, which has softened since then, and on the global economy avoiding major shocks. Some investors are betting high yield will get hammered when the Fed stops buying bonds this summer, on the thinking that spreads between low-risk government bonds and riskier assets such as stocks and high-yield bonds will get wider.

But Grzankowski notes that spreads have continued tightening despite hiccups during the Japanese earthquake and nuclear crisis. He says a pullback is inevitable but that without a major catastrophe it is likely to be minor and, to use a word much in vogue lately, transitory.

Absent a big shock, a weak recovery that has helped bigger companies at the expense of smaller ones should continue, with whatever implications it may carry down the road.

“Investors aren’t buying simply to buy, instead they’re placing optimistic bets on the credit cycle, bets whose risks lie at least 3 – 5 years down the road,” says LeBas. “Optimistic isn’t the same thing as crazy.” Or, at least, not yet.