Junk Bond Yields Hit Record Lows

Global bonds have been roiled by improving growth prospects, but in one of the riskiest parts of the market, junk-rated credit, yields are still falling to all-time lows.

That has left this market looking expensive to some investors, particularly given the potential for central banks to tighten monetary policy and trigger a selloff.

In Europe, yields on junk-rated bonds hit their lowest level on record this week. U.S. high yield is also outperforming other bonds, with yields falling toward the lows reached in mid-2014.

High-yielding debt has been swimming against the so-called reflation trade since November, when expectations of higher inflation and growth triggered a selloff in many bonds.

Investors are still buying junk bonds because the expectation of better growth reduces the likelihood of companies defaulting on their debt. In the U.S. a recovery in commodity prices has lifted a market brimming with oil and mining companies. Funds are also chasing the extra income that these bonds offer.

But that income has been pushed to historic lows at a time when there are risks that the Federal Reserve and European Central Bank will tighten the monetary policy that has been so supportive of this market, including the ECB's massive bond buying program.

"It's been a massive move," said Jeff Mueller, a portfolio manager at Eaton Vance. "There is some concern about that."

"If the Fed hikes and the ECB gets more confident about tightening [policy] then... what you're being compensated for right now is pretty skinny," he said.

The average yield on the EUR283 billion ($307.6 billion) Bank of America Merrill Lynch euro high yield index fell to an all-time low of 2.58% Wednesday. That is down from 4.2% last July, when eurozone government bond yields reached their lowest levels. Yields on U.S. junk bonds have fallen too, from an average of 6.13% at the start of the year, to 5.66% on Wednesday, according to the equivalent BAML index.

A large part of the rally in U.S. high yield has been down to commodity-focused companies, particularly in oil and gas. Though oil futures have recently dipped below $50 a barrel, they are still way above the $26 lows that last year triggered a sell-off in U.S. junk-rated debt. More than 10% of the U.S. high-yield index is issuance from energy companies, more than twice the European level.

In February 2016, yields on U.S. junk bonds in the energy sector peaked at over 20%, while the market excluding those companies was yielding around 8.5%. Now yields on energy sector junk rated bonds are at around 6.5%, only a percentage point higher than the broader market.

Government bonds largely move on the outlook for where central banks will set interest rates. But junk bonds are swayed by other factors too, particularly their perceived likelihood of default.

In Europe, that likelihood currently looks low. Credit raters Standard & Poor's expect the default rate on speculative-grade bond issuers to be just 2% in 2017, below the 3.3% average since 2002.

Better prospects for global growth will continue to soothe fears of default.

But as the European economy heats up and political risks recede in the region, investors believe that the ECB is more likely to unwind its stimulus efforts--including its corporate bond-buying program.

Central bank buying of higher-quality corporate bonds helped to fuel the high-yield sector, as investors moved further down the ratings ladder to look for better returns.

"The favored trade of the year has been to drop down the credit ratings, " said Chris Telfer, portfolio manager at ECM Asset Management.

Many investors and analysts are expecting the ECB to begin winding down its stimulus measure in coming meetings.

The central bank has bought EUR83.4 billion of corporate debt since it announced this stimulus program in March last year.

Not everybody agrees central banks are about to torpedo this market.

Jonathan Butler, head of European leveraged finance at PGIM Fixed Income, said investors understand the ECB will start tapering its bond buying when the eurozone economy recovers.

Mr. Butler sees few major "bumps" ahead for high-yield bonds.

"Europe is growing again. We've got low default rates. On a risk-adjusted basis it looks reasonable...where is the shock going to come from?" he said.

Still, Mr. Butler's firm is reducing the amount of high-yield it holds in portfolios that allow it.

"It's no longer the screaming buy it used to be. That makes life tougher, " he said.

Other investors have also been reducing their holdings, believing that many of the gains are over.

Toby Nangle, Columbia Threadneedle's co-head of asset allocation, reduced the holding of European high-yield bonds in his GBP579.3 million ($750.25 million) dynamic real return fund from 15.1% to 5.7% in the year to March 2017.

"The fundamental credit quality hasn't deteriorated in Europe," said Mr. Nangle, "but valuations have moved sharply over the last 12 months."

Write to Mike Bird at Mike.Bird@wsj.com and Christopher Whittall at christopher.whittall@wsj.com

(END) Dow Jones Newswires

May 11, 2017 10:05 ET (14:05 GMT)