Are we currently in a bubble?
Several market experts, including Carl Icahn and Howard Marks, chairman of Los Angeles–based Oaktree Capital Management, say “maybe.”
But the bubble they are referring to does not involve high-flying Internet and other momentum stocks but rather the junk bond market.
This concern was reinforced recently when French cable giant Numericable Group raised nearly $11 billion in the largest junk bond sale ever. The average yields of the various pieces of the offering ranged between 4.875 percent and 6.25 percent, which was a little below what experts were anticipating, underscoring investors’ growing appetite for risk.
However, at least two prominent investors are warning that irrational exuberance has gripped the speculative end of the bond market.
At the Active-Passive Investor Summit last Tuesday, for example, the audience — especially the media — seemed to overlook comments made by Icahn when he raised the specter of a junk bond bubble. Late in his rambling stand-up comedy routine, Icahn asserted: “High-yield spreads [the interest rate compared to U.S. Treasury yields] are crazy — narrow.”
Icahn asked the audience, what happens when there is some sort of crisis in the world and spreads widen? “Companies will have problems,” he insisted, especially those with variable-rate debt. He is especially worried about BB- and BBB-rated paper. “All of the money pouring into the market will pour out,” he warned. This will heavily depress prices, leading to big losses for investors as spreads widen quickly.
Icahn is not the only person issuing a warning about the debt market. This sentiment was recently raised in a long, thoughtful essay fired off by Marks, who is widely regarded as one of the most prominent fixed-income specialists around. In a letter to clients dated April 14, he asserted: “I’m often asked these days whether there’s a bubble in high yield bonds. My bottom line is consistent: it’s not a high yield bond bubble; it’s a bond bubble.”
Marks explained that all bonds are high-priced these days thanks to intervention by central banks, notably the Federal Reserve. This has pushed rates down very low, forcing investors to take on more risk to squeeze out a little more yield. And as we move further away from the 2008 financial crisis, investors feel increasingly comfortable taking on additional risk.
As a result, Marks pointed out that at first glance one critical metric suggested that junk bonds are way overpriced. This is the yield to worst, which he defined as a yield-to-maturity-type statistic that assumes a bond will be repaid on the call date that is most disadvantageous to the investor who holds the paper, not on its maturity date. “When bonds are selling well above par, call is a threat and the YTW must be considered,” Marks explained.
By this measure, he told clients that the YTW on high-yield bonds has been “in the area of record lows” for the past year. It is currently 5.1 percent on B-rated paper, as measured by the Citigroup High Yield Cash Pay Capped Index, Marks noted. “The differential, or yield spread, between that yield and a Treasury note of comparable duration is 400 basis points,” he added. “Taken in isolation, they appear unappetizing.”
But wait. Before anyone goes out and dumps their junk bonds, Marks emphasized that as long as the yield spread remains within its normal historic range of about 300 basis points to 500 basis points, high-yield bonds are actually trading in a reasonable relationship to Treasuries.
So, he told clients, if you buy high-yield bonds at today’s spread of 400 basis points over Treasuries, they will actually outperform Treasuries over the long run. “If the past is a guide to the future, high yield bonds bought or held at today’s spreads should outperform Treasuries of comparable duration over the period to their maturity,” Marks added. “Normal spreads have historically provided more-than-sufficient risk compensation, and spreads are normal today.”
Marks insisted that junk bonds bought at today’s low yields coupled with normal spreads are likely to return roughly 5 percent and outperform Treasuries if they don’t default. But, he stressed, “if they don’t default.”
Of course, investors are concerned about the prospect of rising interest rates. But investors who hold the fixed-income paper to maturity — rather than trade it on the secondary market — don’t have to worry about that, provided the issuer does not default. Investors will get paid in the end.
Marks’s conclusion: High-yield bonds are less attractive on an absolute basis than at most other times in their history, but no less so than many other asset classes. “As the highest-returning public fixed income securities, they can, if managed with care, provide a mix of return, risk and defensiveness that is very appropriate in today’s market,” he said.
Remember, he added, “if managed with care.”
At the very least, investors should be very aware of the dangerous territory junks bonds have entered.
