So far, 2019 has been very kind to junk bonds, they’ve had the highest returns among US fixed income securities so far this year. This is in stark contrast to their very rough 2018, as you can see in the chart below of JNK, an ETF that tracks junk bonds.
This is typical behavior for the junk bond market, according to Michael Anderson, head of US Credit Strategies at Citigroup, who said “History indicates that high yield typically bounces back from negative return years, so we can understand why many strategists are increasing their 2019 forecasts.”
With that said, the parabolic rally seen in junk bonds has slowed after the Federal Reserve announced that they will be putting a pause on further interest rate hikes for the time being. Since then, we’ve seen significant price increases in US indices and a halt in the junk bond rally.
One of the hottest topics of discussion in the junk bond market as of late has been ‘fallen angels,’ or companies that have recently been downgraded from investment status to ‘junk.’ Having their rating downgraded makes raising capital more expensive and usually has a material effect on the stock price.
One of the most recent fallen angels is PG&E, a California-based utilities company that is facing billions of dollars in liabilities related to the recent wildfires in California, and is filing for Chapter 11 bankruptcy protection. Ratings agencies acted quickly and downgraded the company to junk status.
Future of the Junk Bond Market
The future of the junk bond market is sure to be interesting. Due to the near-decade of historically interest rates, many companies have accumulated of debt, debt that is bound to get more expensive to service in the coming years, as the Federal Reserve has indicated their intentions are to ‘normalize’ interest rates in the coming future.
There are many vulnerable companies in the market right now that have levered up with cheap debt to fund new acquisitions and projects. Those with questionable financials, business models, or those in capital-intensive industries are at a high risk of being downgraded, and receiving ‘fallen angel’ status.
Among them is the Ford Motor Company, who was downgraded to Baa2 from Baa3 in August 2018. Ford is facing significant headwinds between being in one of the most capital-intensive industries (automobiles), facing a $11 billion restructuring effort, and taking on the heavy burden of producing a mass market autonomous car by 2021.
Bruce Richards of Marathon Asset Management recently told Bloomberg that he sees the fallen angels as one of the biggest risks to the bond market at the moment. According to Richards, the $1 trillion in investment-grade BBB bonds have leverage ratios more typical of junk bonds.
Former Fed Chair Janet Yellen recently voiced her concern about the possibility of ‘lots of bankruptcies’ due to the bloated state of non-financial corporate debt. The fallen angels play a key role in a scenario like this. In the event of a downturn, many of them would get downgraded in a short period of time, possibly causing a serious liquidity issue.
When a company is downgraded to junk status, many of their biggest previous lenders are forced to sell their bonds due to internal rules in their firm. In the scenario where many companies are downgraded at once and there are no buyers of their bonds, that can cause a real crisis.
Article By: Patrick Crawley