Junk Bond Market: Trends, History, Effect on Economy

Why the Junk Bond Market Is Plummeting

Shale oil drill using fracking
Pump jacks are seen at dawn in an oil field over the Monterey Shale formation where gas and oil extraction using hydraulic fracturing, or fracking, is on the verge of a boom on March 24, 2014 near Lost Hills, California. Photo: Getty Images News

The junk bond market gives you an early indication of how much risk investors are willing to take on. If investors get out of junk bonds, that means they are becoming more risk averse and don't feel optimistic about the economy. That predicts a market correction, a bear market or a contraction in the business cycle.

On the other hand, if junk bonds are being bought, it means investors are becoming more confident about the economy and are willing to take on more risk.

That forecasts a market upturn, a bull market or economic expansion. (Source: The Reformed Broker, What Are Junk Bonds Trying to Tell Us, August 21, 2013)

Trends

For example, junk bond purchases took off in the summer of 2013 in response to the Fed's announcement it would begin tapering Quantitative Easing. That meant the Fed would buy fewer Treasury notes, a signal that it was reducing its expansive monetary policy and that the economy was getting better. As a result, interest rates on Treasuries and investment-grade bonds rose, as investors started selling their holdings before everyone else did.

Where did the money go? A lot went to junk bonds because investors saw the return was worth the risk. Since the economy was getting better, it meant the companies were less likely to default.

Demand was so high that banks started packaging these junk bonds and reselling them as collateralized debt obligations.

These are derivatives backed by the bundle of loans. They helped worsen the 2008 financial crisis because the companies defaulted on the loans when the economy started to falter.

As a result, few banks sold them until 2013. That's when demand for junk bonds increased. Banks also needed the extra capital to meet Dodd-Frank requirements.

(Source: Housing Wired, Junk Bonds the Penicillin for Fed Tapering, August 19, 2013)

Between 2009 and 2015, the U.S. junk bond market rose 80% to $1.3 trillion. Energy junk bonds rose 180% during that period to $200 million. Investors took advantage of low-interest rates to pour money into shale oil technology. As a result, energy companies comprised 16% to 20% of the high-yield bond market

Oil prices plummeted in 2014, catching many U.S. shale oil drillers off-guard. By September 2015, more than 15% of high-yield bonds were at "distressed" levels. That means they could default in the next nine months. The companies that issue them are having trouble getting loans or refinancing the bonds. The value of the bonds has fallen so far that investors require an interest rate 10% higher than U.S. Treasuries. (Source: "The Big Number," WSJ, September 29, 2015)

On December 12, 2015, Third Avenue Focused Credit Fund closed after losing 27% during the year. It halted redemptions to avoid a fire sale. Instead, it promised to pay shareholders a more fair value on December 16. This shocked markets, as it could happen to other hi-yield fund investors. The sell-off continued. (Source: "Third Avenue Credit Fund Closes," Barron's, December 12, 2015.)

In 2016, about $120 billion of junk bonds will come due. As investor sentiment cools, they demand higher interest rates. For example, Sprint Corp. sold $6.5 billion in ten-year bonds in September 2013 that paid 7.875% interest. To roll that debt over in 2016, it would have to pay 10% to 12% in interest. Instead, the company will cut costs and find other sources of cash. (Source: "Sprint Deals With Junk Bond Trouble," WSJ, January 11, 2016.)

Another problem is that emerging market companies issued many high-yield bonds in U.S. dollars. The dollar's 25% rise means their debt repayments are that much more expensive. That's a big problem for countries, like Turkey, that don't have enough dollars in their foreign exchange reserves. To make things worse, many of these countries export commodities.

Those prices dropped significantly in the past two years. (Source: "Fed Can't Duck the Buck's Strength," WSJ, February 3, 2016.)

Many high-yield funds may not have enough cash on hand to pay off withdrawals. On average, they only hold cash reserves of less than 5%. They should hold 8% or more.(Source: "Fair Game," The New York Times, January 17, 2016.)

History

In the 1780s, the new U.S. government had to issue junk bonds because the country's risk of default was high. In the early 1900s, junk bonds returned to finance the start-ups of companies that are well-known today: GM, IBM, and J. P. Morgan’s U.S. Steel.  After that, all bonds were investment grade until the 1970s, except for those that had become “fallen angels.” Any company that was speculative had to get loans from banks or private investors.

In 1977, Bear Stearns underwrote the first new junk bond in decades. Drexel Burnham then sold seven more junk bonds. In just six years, junk bonds more than a third of all corporate bonds.

Why? The main reason was research published by W. Braddock Hickman, Thomas R. Atkinson, Orin K. Burrell, that showed junk bonds offered much more return than was necessary for the risk. Drexel Burnam's Michael Milken used this research to build a huge junk bond market, which grew from $10 billion in 1979 to $189 billion in 1989. During this decade of economic affluence, junk bond yields averaged 14.5% while default were just 2.2%.

However, Milken and Drexel Burnham were brought down by Rudolph Giuliani and financial competitors that had previously dominated corporate credit markets against the high-yield market resulted in a temporary market collapse and the bankruptcy of Drexel Burnham. Almost overnight, the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year. The junk bond market didn't return until 1991. (Source: Glenn Yago, Library of Economics and Liberty, Junk Bonds)