Junk bond yields have actually fallen over the past month and are historically low.
By Wolf Richter for WOLF STREET.
US Treasury yields have soared to multi-year highs in recent months, and mortgage rates have skyrocketed, and investment-grade corporate bond yields have skyrocketed, and bond funds have dished out losses to their investors, and investors in conservative long-dated bond funds have taken the biggest hit — for example, the price of the iShares 20 Plus Year Treasury Bond ETF [TLT] is down 27% since July 2020 – and all sorts of chaos has erupted in the bond market.
Except in junk bonds, and particularly in the riskiest parts of the junk bond market, where a maniacal hunt for yield rages on as yield chasers don’t believe the Fed’s tightening is for junk bonds, when in fact it is for junk bonds bonds are much more important than investment-grade corporate bonds or government bonds, as this will tighten financial conditions – which is the Fed’s stated aim – making it difficult for many of these junk-rated companies to issue new debt to replace existing ones Serving and paying off debt, which keeps these companies, which are at the riskier end of the spectrum, from defaulting on their existing debt.
Here we go…
The two-year Treasury yield rose to 2.53% by Friday, the highest level since the 2018 rate-hiking streak and before that the highest level since July 2008, when the financial crisis was in full bloom.
The 10-year Treasury yield rose to 2.72% on Friday, the highest since the February-December 2018 era and before that the highest since 2014, at the end of the taper tantrum:
In 2018, the Fed raised interest rates four times and deleveraged assets on its balance sheet at a maximum pace of $50 billion per month. Inflation was below or at the Fed’s target. In December 2018, under Trump’s incessant attacks, Powell began to buckle and reverse course.
Now inflation is nearly three times the Fed’s target and has become a political slut for the White House, and the Fed is under pressure to bring it back down, which it won’t be able to do for a long time. But instead, the Fed will be chasing them higher with rate hikes that are too slow and quantitative tightening too tentative, having made policy mistake after policy mistake over the past two years and compounding those policy mistakes from January 2021, when the Fed began to hike them blow off inflation. So now there will be no Powell pivot to lower rates. Those rates will keep rising, too slowly, and everyone knows it.
AA rated high quality corporate bond yields are also up, but at a slower pace than the corresponding Treasury yield since mid-March, a sign of some yield hunting, with the average yield rising to 3.37%.
During the financial crisis, when 10-year Treasury yields peaked at 4.2%, the average AA-rated yield peaked at 8% as financial conditions tightened even for these companies:
Mania at the riskiest end of the junk bond spectrum.
Single B rated junk bondshowever, has risen only slightly since September 2021 and has fallen since mid-March 2022, while government bond yields have soared. On March 15, they had reached 6.72%. At the end of last week they were down to 6.48%, which remains very low historically.
And this yield is still below the CPI inflation rate! Investors are taking huge risks for still negative, but less negative, real returns.
B-rated bonds are mid-level junk bonds that are considered “highly speculative.” This category is riskier than BB-rated (non-investment-grade speculative) junk bonds, according to my corporate bond credit ratings cheat sheet.
At risk level BB, many companies face sudden downgrades and defaults when financial conditions tighten. And every time financial conditions tighten, there are waves of defaults and yield spikes, as mentioned earlier:
CCC or lower rated junk bonds represent the highest risk category of companies, those whose cash flow is nowhere near enough to cover debt payments and with large losses – companies borrowing on borrowed time, so to speak. This category of bonds ranges from “significant risk” for CCC-rated bonds to “risk of default with little chance of recovery” for C-rated bonds. The next notch down is D for Default, according to my guide to corporate bond creditworthiness.
The average bond yield rated CCC or below also fell from mid-March (10.36%) to 10.11% now. During this period, as Treasury yields soared, the spread on Treasury yields narrowed by 81 basis points, a sign that this end of the market is in la la land.
This is also the category of bonds that investors are fleeing to for a yield in excess of the 7.9% CPI inflation rate. And they take huge risks for their capital just to hedge against inflation.
The current average yield is near historic lows at 10.11%. Many of these bonds tend to default when financial conditions tighten to the point where companies run out of investors to provide new money to pay off existing investors. At that point, a debt restructuring, often before a bankruptcy court, can ensue, with holders of these bonds incurring large losses as these bonds may have been unsecured or backed by collateral that has become nearly worthless.
That means junk bonds have some catching up to do, and those companies that don’t have enough cash flow to service their debt will face a new reality of tightening financial conditions, as the Fed has set out to do by tightening monetary policy . But for now, this segment is in la-la land, where investors are still madly looking for yield.
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