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Red flag waves over junk bonds as money pours into high yield

Traders signal orders on the financial floor at CME Group's Chicago Board of Trade.
Tim Boyle | Bloomberg | Getty Images
Traders signal orders on the financial floor at CME Group's Chicago Board of Trade.

Yet another warning flag was raised Wednesday over the high-priced junk bond market.

In the bond market, you're only as good as your promises, and Moody's latest report on covenant quality shows that some of the promises in the high-yield market are looking pretty weak.

Moody's said the quality of covenants that govern high-yield corporate debt are at a record low, while high-yield prices are close to record highs and investment in the sector continues to grow.

The average covenant-quality score for high-yield bonds in February worsened, rising to 4.36, from 3.84 in January. Moody's 1-to-5 scale puts 5 at the weakest, and February's score is the weakest since Moody's began reporting them in January 2011.

Moody's officials caution that February's score most likely looked particularly poor because it covered a much smaller universe of issues than last year or even several months ago.

Bond strategists say it's too early in the cycle to ring the bell on high yield, though they look at the underwriting quality as a warning. The Fed is still holding rates low for a long time to come, and its quantitative easing program is being curtailed very slowly.

"They've been warning of this deterioration, diminishing covenants in these securities for some time. It's another one of the flags that skeptics toward the asset class point to," said Edward Marrinan, co-head of market strategy at RBS Americas.

"We're worried about it any time we see evidence" that underwriting conditions or standards weaken, Marrinan said. "These are obviously warning flags to credit people. We are not fearful at this moment that there's going to be a correction or violent correction for high yield without there being a catalyst for correction."

Alex Dill, head of covenant research at Moody's, said quality of bond covenants started falling off at the end of last summer, and it particularly showed up in September across a representative sample of the market. Moody's officials said some covenants have been lacking in two areas—controls over indebtedness levels and cash payouts to shareholders—and that automatically gives those issues the lowest score.

"Once an underwriter puts out an aggressive structure in the market with that type of market dynamic, that structure takes hold and gets entrenched. For the time being, we're going to have low quality and it would take a considerable market event to change the dynamics," said Dill.

Strategists say the low U.S. default rate—now 2 percent—is one reason why high-yield bonds are attractive. The average default rate is about 4 percent, and Marrinan said it peaked at about 15 percent during the financial crisis.

According to Lipper, a total $2.16 billion flowed into high-yield corporates so far this year. That compares to outflows in the lowest-rated investment grade bonds of $556 million, and inflows of just $213 million into A rated corporates. All investment grade corporate bonds saw inflows totalling $18.3 billion.

The Yield Book high yield cash index was at 397 basis points on Wednesday, above the five-year Treasury, and its all-time low was 237 in 2007. "We do recognize the yields and spreads are near the tight end of their historic ranges, but we also look for the catalyst that might cause a correction or a significant degree of uncertainty," Marrinan said.

In high yield's favor, fundamentals are stronger than normal—including record high corporate earnings, lower debt levels and higher cash levels, he said.

Greg Peters of Prudential Fixed Income said the market is still attractive and the wave of merger activity is actually helping the junk bond world because some of the weaker credits are being absorbed by stronger companies.

"On the investment grade side, it's just a de facto leveraging. This is a de-leveraging event most of the time, so it's an important element in the market for sure. Bottom line, I think we're a little early to be proclaiming from the rooftops that the market is in a very bad place fundamentally," said Peters, managing director and senior investment officer.

"I think that's a separate and distinct issue from where they're trading. I would agree there's not a lot of juice left, and there's some excess for sure, especially in triple Cs. There's still value here and there. I think the higher-quality names can richen relative to investment grade. The lower types of echelon names, there's not much left and you are taking on a lot more credit risk in that part of the market."

Doubleline's Jeff Gundlach this week was among the latest voices to raise the alarm on the high-yield market, saying corporate bonds are overvalued and with the average junk issue yielding 5.4 percent and trading above 104 cents on the dollar, the market is too rich. He noted that one reason junk is too rich is because high-yield bonds went up in value while other bonds went down in value last year.

But other strategists say in an environment where Treasury yields are in a relatively low range and the Fed is not moving to raise rates, high-yield bonds are not a big risk.

"It's something to watch, but this takes awhile to play out," said Peters. "What you see in every single cycle is behavior just like this. Deals get a little more stretched. There's more leverage in the deals. This is not a new phenomenon. This happens every single cycle, but at the same time it's not a huge proportion of the overall market. It's something to keep an eye on but it's not going to change the overall market."

"It's good to be aware of these risk factors but I think it's a little early. At the end of the day, what drives high yield is the fundamental price and unless you think defaults are going to pick up—and they're on the floor right now—the only risks you have out there are exogenous risks. Then that's not a junk issue. That's a systemic issue."

Marrinan said one driver of the high-yield market was the exodus of investment from emerging market debt into U.S. corporates. For now, the market is attractive.

"There will be a point at which it has to correct along with all other risk assets, but periods of correction come about because there are catalysts or data or events that prompt risk takers to become risk averse," he said. Marrinan said it could be geopolitical risk, missteps by policymakers or a shift in fundamentals that would change the outlook.

As for the Moody's score, officials there describe a new type of bond covenant. "High-yield-lite bonds represented 39 percent of last month's issuance, approaching the 41.7 percent record set in September 2011 and a significant increase from 10 percent in January," Moody's senior covenant officer Evan Friedman said in a statement. "These bonds lack a debt incurrence and/or a restricted payments covenant and automatically receive our weakest score of 5.0."

Moody's said the average covenant quality score for bonds rated Ba worsened to 4.58 in February from a below-average 4.43 in January. They accounted for 33 percent of high-yield issuance last month, a bit above the average of 28 percent. Bonds rated Caa worsened to an average 4.29, close to December's score of 4.39. These bonds generally have been weaker than the historical average of 3.45, but amounted to only 11 percent of last month's issuance.

Moody's said the weakest full high-yield bond package came from QMerger Sub, which scored 4.54. Also on the low end were bonds from Regal Entertainment Group and AMC Entertainment, which scored 4.51 and 4.43, respectively. Moody's said the better covenants were on bonds from Greektown Holdings/Greektown Mothership, at 2.35, followed by bonds from TreeHouse Foods and Century Intermediate Holding Co. 2, at 3.37 and 3.68, respectively.

—By CNBC's Patti Domm. Follow her on Twitter @pattidomm.

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