Credit Thaw Spreads to Junk Bonds, but Default Rates still Rising Sharply
Credit markets continue to improve since March with every segment of the fixed income curve enjoying an impressive rally or a compression of yields. At first, most credit spreads failed to join the broader rally in stocks off the March 9 lows. But now the entire gang has showed up at the party, including junk bonds, high quality corporate bonds, mortgage-backed securities, emerging market debt and even some leveraged loans. Only Treasury bonds are in the loss column this year following a stellar 2008.
Also bullish is the trend in short-term credit markets where 90-day LIBOR rates have sunk below 1% this week to 0.99% -- the first time they’ve traded below 1% since the advent of the credit crisis in late 2007.
But the biggest gains lie in junk bonds lately. Just two months ago, dealers couldn’t give away a junk bond issue; but since late April several new deals have hit the pipeline as investors assume more risk.
The spread or difference between ten-year Treasury bonds and the Merrill Lynch High Yield 100 Index has shrunk to just 671 basis points, or 6.71%, from a high of almost 14% last fall. Merrill Lynch still publishes several high yield indices but the most widely followed, the High Yield 100 Index, now yields 9.87% compared to 17.03% last October. Over the last four weeks, yields have crashed.
In April, several deals were financed in the junk bonds (high yield) arena that couldn’t get a bid back in February. Combined with significantly lower yields, junk bonds have already gained 12.6% in the second quarter.
Still, despite the hoopla, investors should avoid buying this riskier segment of credit now and focus on safer investment grade bonds and TIPS. Even short-term Treasury bonds look attractive at these levels to supplement puny money-market yields following a ratcheting of short-term rates since late March.
In all probability, this is a bear market rally – similar to the November to January rally.
There is a looming default cycle that has yet to be fully discounted by the market; default rates stand at just under 6% now compared to at least 10% or more in previous recessions. The market has incorrectly discounted the worst at this stage of the economic cycle because this remains a deep-rooted credit deflation. Default rates are likely to top north of 15% before it’s safe to aggressively accumulate junk or high-yield bonds.
Meanwhile, riskier bonds and stocks have come a long way since reaching the edges of the abyss in early March. I reckon we’re severely overbought at these levels and a new round of profit-taking lies ahead this spring or summer. Keep most of your powder dry.
Also bullish is the trend in short-term credit markets where 90-day LIBOR rates have sunk below 1% this week to 0.99% -- the first time they’ve traded below 1% since the advent of the credit crisis in late 2007.
But the biggest gains lie in junk bonds lately. Just two months ago, dealers couldn’t give away a junk bond issue; but since late April several new deals have hit the pipeline as investors assume more risk.
The spread or difference between ten-year Treasury bonds and the Merrill Lynch High Yield 100 Index has shrunk to just 671 basis points, or 6.71%, from a high of almost 14% last fall. Merrill Lynch still publishes several high yield indices but the most widely followed, the High Yield 100 Index, now yields 9.87% compared to 17.03% last October. Over the last four weeks, yields have crashed.
In April, several deals were financed in the junk bonds (high yield) arena that couldn’t get a bid back in February. Combined with significantly lower yields, junk bonds have already gained 12.6% in the second quarter.
Still, despite the hoopla, investors should avoid buying this riskier segment of credit now and focus on safer investment grade bonds and TIPS. Even short-term Treasury bonds look attractive at these levels to supplement puny money-market yields following a ratcheting of short-term rates since late March.
In all probability, this is a bear market rally – similar to the November to January rally.
There is a looming default cycle that has yet to be fully discounted by the market; default rates stand at just under 6% now compared to at least 10% or more in previous recessions. The market has incorrectly discounted the worst at this stage of the economic cycle because this remains a deep-rooted credit deflation. Default rates are likely to top north of 15% before it’s safe to aggressively accumulate junk or high-yield bonds.
Meanwhile, riskier bonds and stocks have come a long way since reaching the edges of the abyss in early March. I reckon we’re severely overbought at these levels and a new round of profit-taking lies ahead this spring or summer. Keep most of your powder dry.
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