Alarm bells are ringing unheard in a world of optimism

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High Yield Bond Updates

Alarm bells are ringing, but is it any wonder that no one hears them? The world longs for optimism. Witness the joy of a British teenager winning the US Open or the interest in the Met Gala, which made headlines, including this one.

Even in financial markets, the gauge that much of the American public considers a barometer of our country’s economic well-being – the $ 51 billion US stock market – has set record after record. And yet, there are good reasons to be concerned.

If a growing number of Wall Street analysts are to be believed – and there’s a compelling argument that they should be – the risks in one corner of the financial markets are starting to rise.

This year, investors hesitated deal after risky deal as they searched for places to park their money. The loans have been gigantic, pushing the U.S. corporate bond market to nearly $ 11 billion, more than a tenth more than it was at the end of 2019 before the Covid-19 pandemic , according to Sifma, the securities industry trading group. But the terms on which these fund managers agreed to lend were surprisingly poor.

Rating agencies are already warning that the seeds of the next crisis, or at least the next cycle of failure, are being sown today. The pain will be particularly acute in the junk bond and leveraged loan market. This is where the riskiest companies fund themselves and where the private equity buyout shops fund their buyouts.

Analysts at credit rating provider S&P Global warned this month that growing risks in this market mean investors should demand more appropriate compensation for lending to it. But it turns out that “now the opposite is true,” analysts said.

As an example, Coinbase, the junk-rated cryptocurrency exchange that has found itself in the crosshairs of regulation, this week locked in a 10-year bond with an interest rate of just 3.625%. . The U.S. government paid less than half a percentage point below that amount to borrow as recently as 2018.

Marc Lasry, managing director of Avenue Capital Management, said this week at a conference that his company was forwarding “hundreds of deals” with the idea that in the years to come, many borrowers would run into problems.

“There are a lot of morons out there and a lot of people make huge mistakes,” he said. These fools have accepted weaker protections because so many other investors are willing to lend if they push back. The rally in stocks and falling borrowing costs have made financial conditions in the United States as flexible and easy as they’ve ever been, suggests an index compiled by Goldman Sachs dating back to 1982.

Column chart of privately funded acquisition volumes, by year (in billions of dollars) showing debt buyout stores closing deals at a record pace

Analysts at the Moody’s rating agency this week estimated that a lack of investor protection would cause private equity funds, which are heavy users of the junk bond and leveraged loan markets, to back down. pay large dividends to recoup the money they spend to buy out companies.

And private equity has certainly been active. Leveraged buyout activity has already reached an all-time high, surpassing the 2007 record, according to Refinitiv.

Therein lies a problem. Moody’s own analysis of corporate performance during the pandemic showed that private equity-backed groups were more often in default than the average high-yielding company. Excluding the oil and gas sector, 5.2% of U.S. companies rated as garbage defaulted between 2020 and 2021. For private equity firms, that figure stood at 8.4%.

So why lend at such low rates when investors know how a cycle of default will ultimately play out? In a forthcoming article in the Journal of Portfolio Management, New York University professor Edward Altman and Stanford University professor Mike Harmon argue that investors lend on “aggressive and very optimistic” expectations. “.

“By subscribing to a set of possible outcomes at the bullish end of the odds curve, investors appear to be making a very skewed bet on the downside,” they write.

In short: in the years to come, these investors could be left behind by taking care of the losses. During the financial crisis, major write-downs on credit portfolios hit Wall Street banks. But now the vast majority of these loans are made by credit funds on behalf of pensions, endowments and regular family investors. The system may not collapse, but retirement accounts may be affected.

Wary of risk when the financial world looks so rosy, some fund managers are pulling money off the table in search of safer bets.

That might not be the approach that shines in the short term – especially when loan yields to low-rated groups look so attractive compared to, well, whatever is on offer. But if we learned anything from the Met’s red carpet this week, it’s that not all bets pay off.

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Twitter: @ericgplatt

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