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Junk Bonds

With the market on edge in anticipation of a possible rate hike by the Fed, Gundlach tried to throw cold water on the idea of a rate hike in light of what he characterized as the current extremely weak condition of the high-yield bond market.

Jeffrey Gundlach, the founder and chief investment officer of Doubleline Capital, known in the financial press as the King of Bonds, took to the airwaves and the internet last week with a cautionary message for Federal Reserve Chair Janet Yellen and the other governors. With the market on edge in anticipation of a possible rate hike by the Fed, Gundlach tried to throw cold water on the idea of a rate hike in light of what he characterized as the current extremely weak condition of the high-yield bond market.

“We are looking at real carnage in the junk bond market,” Gundlach said in his extended market commentary made available by Webcast. Gundlach went on to cite a number of other asset classes flashing warning signs of rapidly deteriorating market conditions, including weakness in wide range of commodities, such as copper, where prices have fallen by almost 40% in the last year.

Not that we think Gundlach’s warning is likely to have its desired effect on the Fed Governors in their upcoming deliberations. The fact of the matter is that putting a dent in the junk bond market is probably something the Fed Governors are glad to have accomplished (without even having had the occasion to raise short term rates yet) in order to restore some discipline and deter the chase after yield that has come to characterize the U.S. capital markets in recent years. After 7 years of zero interest-rate policy (ZIRP) from the Fed, investors have gorged themselves on high-yield issuance, with an estimated $1.8 trillion of junk bonds outstanding now in the U.S.

Of course we don’t intend to minimize the extent of the damage in the junk bond market in recent weeks.  In fact, calling it carnage may be a bit of an understatement. The latest bond market report from Standard & Poor’s showed the distress ratio in the U.S. bond market rose to 20.1% as of November, up a full percentage point since October and at the highest level since the depths of the financial crisis in 2009.  S&P considers a bond distressed when its price falls to the point that the yield is 1000 basis points above U.S. Treasuries. More than 228 U.S. issuers had fallen into that predicament as of the end of last month, representing more than $180 billion bonds outstanding.

 

S&P distress ratio for junk bonds and leveraged loans
S&P distress ratio for junk bonds and leveraged loans

 

When the distress ratio first began to climb earlier this year, issuers in the oil & gas sector and, to a lesser extent, metals & mining accounted for a vast majority of bond market distress. But in recent months, the pain has spread to a much broader swath of the American economy, including the restaurant sector (with 21.4% issuers distressed), media & entertainment (17% of issuers distressed), high tech companies (19% distressed), chemicals & packaging (16.1% of issuers distressed) and financial institutions (12.6% of issuers distressed).

Indeed, this is primarily bad news for bond funds and their investors who are now facing huge losses in their portfolios. Already as of last week, the Wall Street Journal reported the first such bond fund blow up, when a high-yield bond fund managed by Third Avenue Investors announced it was putting up a gate and freezing redemptions while it set about to liquidate its holdings. It’s not hard to imagine that more high yield funds may soon follow.

But what does this mean for the deal market as well as the broader economy? In past business cycles, rising bond market distress has been a warning sign of a general downturn soon to follow. But such an outcome seems far from preordained, as Yellen and the Fed Governors set about to try and thread the needle, by damping down some of the speculative excess without triggering a recession.

In the meantime, here at BankerBay, we see the deal market place continues to power along, with yet another record month of approved qualified deals in Nov 2015 of $2.4 billion. While the S&P ratio provides a clear sign of increasing distress among junk bond issuers, we still see strong evidence of continued vibrancy of middle-market business all around the globe.

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