High-Yield Bonds: Not So Junk Anymore

The new Fed balance sheet winning number is $6.08 trillion!

But the truly winning lottery ticket was US high-yield (“HY”) aka junk, bonds. These lower-rated types of debts, as the Fed fired another $2.3 trillion bazooka, expanding its asset shopping list to also include junk bonds (for the first time ever).

As a result, US junk bonds (HYG, JNK, BKLN, HYLB, SHYG, SJNK, USHY, SRLN) rally most in two decades, with Fed now a buyer.

After reaching 1100bps on March 23, the widest level since the global financial crisis, the average risk spread of US junk bonds to US Treasuries has narrowed 86bps to 785bps – the lowest level since March 13.

The funny (or scary) thing is that the Fed hasn’t yet exhausted its ammunition. There’s more it can do as part of the war against the virus, and this is a wartime degree of commitment to credit policy.

While the Fed announcement contains a few surprises, including its purchase of junk bond ETFs, not all HY debts are treated equally.

For example, if you’re jumping on collateralized loan obligations (“CLOs”) focused operations/managers (Oxford Lane (OXLC), Eagle Point Credit Company (ECC), Ares Management (ARES), Saratoga Investment (SAR)), you might want to rethink your stance before you automatically jump into those, because there’s a catch to the Fed’s purchasing program: It will only buy AAA bonds of CLOs that hold newly-originated leveraged loans, rendering the vast majority of the market ineligible.

ChartData by YCharts

Not everyone is happy about Fed getting into junk bonds. That’s quite understandable when the Fed is using public money to bail out private companies that (at least, some of those) were acting irresponsibly.

If people were upset about banks (where the CEOs were making $50m a year) being bailed out in 2008, how are they going to feel about private equity firms (where the CEOs are making $500M a year) being bailed out now?

Thing is, if the Fed ends up bailing out everyone, no one is actually going to be bailed out. I mean, you can send each and every American a $1M check, but will it turn all Americans into millionaires?

Similarly, if you allow the poorly managed junk operations to get away with it, does it make them any better managed? As a matter of fact, you reward those who acted irresponsibly and, indirectly, encourage such mismanagement by those who may haven’t acted in the same manner beforehand.

How can we understand/explain the biggest weekly gain for US stocks in 46 years amid a pandemic that’s sending the global economy into recession?

Junk bonds rallied the most since 1998 as the Fed delves into buying the debt. So much so that junk-rated companies that had no chance tapping the credit markets are now lining up to raise more debt.

Because you know, there’s nothing better to tackle a debt problem with issuing more debt, especially when the “big brother” is having your back.

After reaching 1100bps on March 23, the widest level since the global financial crisis, the average risk spread of US junk bonds to US Treasuries has narrowed 86bps to 785bps - the lowest level since March 13.

Even if the economy starts to re-open in mid-May, more than 20 million Americans will have lost their job by then.

The economy is likely to have contracted around 13% peak to trough, more than three times deeper than the global financial crisis.

Yet, it’s almost as if nobody is even going to worry about 2020.

We didn’t see this coming, but we’re not complaining either, because in light of the tremendous risk that we still see for this market, we were buyers of HY debt recently, as this is where we’ve identified the best risk/reward.

As a matter of fact, we believe/d that HY bonds are likely to deliver a higher total return than stocks might, over the next year or two. With the Fed now providing a safety net, this wouldn’t be only a potential greater reward but also a lower risk.

Getting a higher return while taking a lower risk? Sounds quite attractive to my ears.

Wheel of Fortune by the Fortune Teller

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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