Junk For Sale: Purchasing a Ticket for Disaster

In a bubble economy many metrics that would otherwise be measures of concern end up becoming the norm – until reality sets in. One of these metrics is the issuance of junk bonds. Junk bonds represent bonds issued by companies that are at high risk of defaulting when compared to the bonds issued by well-established companies.

According to Financial Times:

“Companies have issued $140bn in the US junk bond market over the past three months, outpacing a record dash for cash in the second quarter of 2020 when groups raced for funding to survive the shock of coronavirus…The three biggest issuance quarters on record have all fallen in the past 12 months, helping to propel the size of the US high yield market towards a record $1.5tn, according to data from Ice Data Services, from $1.2tn at the start of last year.”

When we look in particular at the historical view of the US High Yield market we see that yields are at a record low (see graph below). This means that as demand for bonds goes up, the yields go down; and when yields go down, the market price of these bonds goes up. The demand for these junk bonds is mainly being driven by the FRB’s low interest rates policy, which is incentivizing investors to flood to market that generate a return above holding cash. The current rate yield of 4.45% is significantly above keeping cash at practically zero at the bank. The risk in holding these junk bonds is that, as can be observed in the graph, yields shoot up fairly quick when sentiments turn sour, which will inevitably lead to a collapse in value for these bonds. If the 2008-2009 period is of any indication, then expect to see yields in the 20-30% range, at a minimum, when the economic bubble finally pops; and when that happens, the junk bonds will live up to their name.