Junk Bond Yields Soar as Defaults Rise

September 29, 2015Bondsby EW News Desk Team

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Junk bond yields have risen above 8% as investors’ fear a growing number of defaults are looming amidst weak sales and low commodity prices.

According to the Bloomberg World Bond Index, which measures high yield debt issued worldwide, the average yield of high-yield debt has risen to over 8%, while the yields on U.S. corporate bonds is nearing 8%. The yields on commodity-based company debt, particularly energy companies, is soaring the highest while bond prices fall.

The rise in yields is largely due to rising default risk. As commodity prices fall and operating margins fall and turn negative, analysts expect defaults and bankruptcies to rise throughout the market. As a result, investors are demanding a higher yield on debt.

Creditors are also fretting that a knock-off effect of defaults could drive bond prices lower for non-commodity based companies, causing debt prices market-wide to rise in anticipation of higher default rates.

More Defaults Expected

Default rates expect to rise throughout the U.S. and Canadian markets, particularly amongst non-investment grade debt. One debt-rating firm has said expected default rates are expected to rise to more than 5, up sharply from less than 2.5% a year prior. Meanwhile actual default rates have risen sharply to over 3%, and analysts expect that rate to rise further.

Profit margins are falling because of sluggish spending, falling energy costs, and rising competition.  Some debt ratings firms warn that an acceleration of corporate debt, which rose 7% in the second quarter of 2015, and a fall in corporate profits, which has fallen to less than 7%, signals a greater risk of missed payments, defaults, and bankruptcies amongst large debt-issuing firms.

Capacity utilization, which measures the total use of available fixed capital to produce goods and services, has fallen considerably since the end of the Global Financial Crisis. Analysts cite a falling cap utilization rate as a signal of greater default risk, as costly maintenance of infrastructure is not offset by strong revenues. Capacity utilization fell to 67.2% in the beginning of 2009, when defaults rose to 14.9%, over ten times as much as they had been 18 months prior.

While capacity utilization has improved since its recessionary low in 2009, it is still below historic norms at less than 78%. That is nearly 5% less than the average cap utilization rate in the 1980s and 1990s.

Divergence in Asia

Asian bonds are seeing greater demand despite weak economies in Japan and China, which is causing some analysts concern that a flood of capital is overcrowding the market and causing yields to fall too low relative to the risk of defaults. In China, some state-owned enterprises (SOEs) have seen so much demand for their debt that their corporate issuances denominated in U.S. dollars have seen yields fall to less than 4% for 5-year terms. While that has made borrowing costs extremely low for Chinese firms, it also signals the market is failing to be sufficiently compensated for risk, as the debts are trading at a lower yield than many U.S. firms.

In Japan, investors are skirting energy firms, fearful that they are likely to default without the government intervention that SOEs can rely on. One analyst told Bloomberg News that investors are unwilling to lend to energy sectors, causing traders to lower their exposure to the company’s corporate issuances.

In the U.S., high yield bonds are at their highest point since May 2012 and trading at the highest spread relative to the U.S. Treasury in over three years. Corporate to Treasury spreads have risen nearly 200 basis points from their low in 2015, as demand for credit dries up in the bond markets.

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