Is the Weakness in High Yield Signaling a Recession?

 

The Wall Street Journal notes that U.S corporate high-yield bonds are down 2% this year, which would be only the fifth annual loss on a total-return basis since 1995. High-yield bonds are issued by heavily indebted companies that are more likely to default, and declines in their value can signal a coming downturn. George Bory of Wells Fargo Securities sees a “meaningful disconnect between equities and high yield.” Defaults on such bonds jumped from 2.1% to 2.6% and is predicted to rise to 4.3% in 2016 (above the 30-year average of 3.8% for the first time since 2009), according to New York University Finance Professor Edward Altman. He sees increasing defaults as a signal that the bull run in credit is ending, noting that declines in these junk bonds are often a signal of stock-price declines. Further, “in most high-default periods we’ve seen in the past, the rise in default rates precedes a recession,” Altman said. Bank of America credit strategist Michael Contopoulos notes that creditors appear to be avoiding the highest risk bonds, which “typically means bad things for the market, with a default peak within 20 months.” Contopoulos was one of few to predict the decline in high-yield bond rates at the start of the year.

Energy junk bonds are down 14%, and heavy industry 15%, for the year. Pharmaceuticals are down 8% since September.  The Journal describes these falls as “fast and furious,” noting that Wall Street banks are subject to new regulations that limit their ability trade in junk bonds and, thus, to cushion the fall. Nonetheless, some see opportunity. Steve Rocco of Lord Abbett & Co. said: “what we’re spending time on now is distressed bonds selling at 60 cents on the dollar” because “we see opportunity there.”