Sunday, April 13, 2014

Welcome To The Euphoria Stage Of The Junk Bond Bubble

The year 2013 tallied the largest issuance of junk bonds in history. It was the highest in gross issuance and the highest in percentage terms of all corporate debt issued. The average yield on junk bonds was the lowest in history (meaning investors paid the highest price for these bonds in history).

What has changed in 2014? Nothing. People love junk debt. Are junk bonds now the largest bubble in the United States? (this position was formally held by bitcoins; see Bitcoin Crashes 70% In Four Months)

The only thing more ridiculous than purchasing junk bonds (bonds that have a very high likelihood of defaulting) at very low rates of return, would be to remove the requirements of borrowers around actually pay the money back. Do they create junk bonds like this? Yes, they are called covenant lite bonds. Here is the definition from investopedia:

"A type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower. The issuance of covenant-lite loans means that debt is being issued, both personally and commercially, to borrowers with less restrictions on collateral, payment terms, and level of income."

Obviously this can only be a tiny sliver of the bond market because no one could be duped into buying such a bond after watching homeowners walk away from trillions of dollars worth of mortgage debt after it went bad. Right?

Unfortunately, wrong.

The chart below shows that covenant lite bonds now make up 50% of  bond issuance, making the 2007 toxic debt binge look mild in comparison.

So what happens when interest rates rise? Buckle up.


  1. Where do these junk bonds end up? Hedge funds are too smart for them right? are they held by unsuspecting mutual fund shareholders? closed end funds? if you have some insight i would really appreciate it

    1. I do not have specific data on the percentages purchased by individual groups (if I come across it I will write about it). In a broad sense, they are being purchased by everyone. Foreign entities, hedge funds, mutual funds, individuals through managed accounts, insurance companies and pensions. During this phase of the business cycle defaults are low so people extrapolate forward that they will stay low forever. Looking through this lens they only see the extra 2 to 3 percent return they can get investing in junk over safer bonds. It is the reach for yield. Some hedge fund managers, such as Jeffrey Gundlach from DoubleLine, have been sounding the alarm. He said last week that high yield corporates (junk) are the most expensive they have ever been in history.