Lowest-rated junk bonds slump as others win

New York

THE economy is humming and the stock market is hitting new highs, but a small corner of the high-yield bond market is going in the other direction, amassing some big blow-ups.

Investors have been demanding significantly higher yields to lend to companies including McDermott International Inc, Frontier Communications Corp and California Resources Corp in recent weeks. So much so that spreads in an index of debt with the same or lower ratings - the riskiest tier of junk, known as CCC - just breached 1,000 basis points for the first time in more than three years.

The turmoil is largely being viewed as an isolated event. After all, investors are still demanding relatively small premiums to own most junk bonds. The biggest sell-offs are concentrated in a handful of companies with lots of troubles specific to themselves.

But there are some reasons why investors might take notice. One can be found just looking at the last sell-off in junk bonds in 2015 to 2016, said Christian Hoffmann, a portfolio manager at Thornburg Investment Management Inc, which manages US$43 billion.

While a few outcasts, such as Sprint Corp, initially had problems, "it wasn't long before the whole market had fallen out of bed, spreads broke through 800 and everything was for sale," he said.

In addition, more companies are still being downgraded than upgraded. In fact, downgrades by S&P Global Ratings in the speculative-grade debt market are outpacing upgrades by the most since 2009.

And plenty of cracks continue to emerge in leveraged debt markets. Defaults have spiked for both bonds and loans and fears of an economic downturn persist. There have long been concerns the next wave of financial pain could emanate from higher-yielding corporate debt.

By many accounts, though, the breach of 1,000 basis points isn't a sign that the much-anticipated reckoning has begun. Debt with the deepest junk rating of CCC and below represents only 13.3 per cent of the US$1.24 trillion Bloomberg Barclays junk bond index, less than the 16.3 per cent at the end of 2014, according to Barclays research.

The index is also being skewed by specific names and sectors; some debt held by Frontier, the communications firm struggling under a nearly US$18 billion debt pile, accounts for 3.2 per cent of all bonds rated CCC and below, according to Barclays.

The bonds are also being hit by issues in energy-related sectors, and securities tied to those represent about 12 per cent of the high-yield market as a whole. Energy is the only sector yielding negative returns in the high-yield debt market, falling over 2 per cent compared to a nearly 12 per cent gain for its index.

The debt could pose problems down the road because some companies will likely struggle to refinance as their borrowings fall due, according to Ken Monaghan, co-director of high yield at Amundi Pioneer.

"For a lot of these companies, the question is whether they will have access to capital at all," he said.

Still, the junk bond market has tilted towards higher-quality in the last five years, with debt rated BB now accounting for 48 per cent of the broader high-yield market, according to Bloomberg Barclays index data. It was 43 per cent at the end of 2014.

Leverage levels at companies in the BB ratings tier have declined to about 3.9 times earnings in the last quarter from 4 times at the end of last year, according to Barclays. The bank expects the high-yield bond default rate to be 3-4 per cent next year.

Kevin Mathews, global head of high-yield debt at Aviva Investors, said the breach of 1,000 basis points signals the market is idiosyncratic.

"Energy and individual credits are pushing CCCs out," he said. "Don't read too much into what the CCC market does versus the BB and B buckets." BLOOMBERG