The supply of U.S. companies with junk-rated debt is rising just as investor demand for higher yields is climbing.
Moody's reports a two-year high in company debt rated B3 negative or worse—a.k.a. junk—as part of a trend that has seen the list of 184 companies grow by 26 percent over the period. The rise has been led by oil and gas firms, which accounted for 12 of the 28 additions to the junk list in February.
What's more, the roster would be even longer but for companies falling off the list due to reasons including filing for bankruptcy. Of the 18 issuers no longer rated, 39 percent filed either for bankruptcy protection or "distressed exchange, and 33 percent withdrew, with just 28 percent getting off the list due to upgrades."
"This is a reversal from the previous two quarters, when most companies left the list via ratings upgrades," Moody's said. "If this reversal continues, it could signal tough times ahead for speculative-grade issuers."
Not so far, though.
Fueled by low default rates and generally favorable credit conditions, investors in 2015 have been pouring money into funds that invest in high-yield debt. In fact, the previous six weeks before the most recent week had the highest level of flows to junk funds since the financial crisis in 2008 and 2009, according to Morningstar.
Flows to junk-focused funds have taken in a net $12.2 billion so far in 2015 as part of a broader interest in fixed income amid a turbulent stock market, Bank of America Merrill Lynch reported. In addition to the big cash attraction to junk, high-grade bond funds have seen net inflows of $36.4 billion.
High-yield bonds have outperformed both stocks and fixed income as a whole. The SPDR Barclays High-Yield Bond exchange-traded fund is up 2.3 percent year to date, outpacing the Barclays U.S. Aggregate Bond Index, which is up 1.5 percent, and the S&P 500, which has climbed 1.1 percent for the year, thanks primarily to a big rally Monday.
ETFs that focus on high yield have seen solid inflows. A look at the top 10 funds by asset size, flows and performance for the year:
Even with low economic growth and a sharp lull in corporate profits, industry experts predict relatively little turbulence in the high-yield market.
"We continue to expect the high-yield market to outperform investment-grade for the remainder of the year," David Sekera, corporate bond strategist at Morningstar, said in an analysis of the sector. "Based on our expectation that GDP growth in 2015 will range between 2.0 percent and 2.5 percent, macroeconomic fundamentals in the United States should be generally supportive of credit risk and dampen defaults through the rest of the year. The combination of modest economic growth and low interest rates should keep default rates from rising meaningfully this year."
Default risk is at just 1.7 percent, according to Moody's, well below its 17.3 percent in March 2009. There were 290 issuers on the junk list back then, compared with the 184 now.
However, investors probably should be looking past this year, considering that high-yield bond maturities are typically longer than investment grade—seven or eight years, on average.
In exchange for the alluring yields of junk bonds, which are currently about 6.1 percent on average, investors are sacrificing protection against defaults. Covenant quality, or the types of restrictions placed on issuers for financial practices after issuing the bonds, is at record low levels.
Moody's rates covenant quality on a scale of 1 to 5, with 1 being the most restrictive and 5 the least. In February, the average covenant score for all new bonds was 4.51, worse than the previous apex of 4.43 in November. The tolerance for weaker restrictions on practices such as taking on more debt or making risky investments represents an increase in faith that may not be justified when the bonds hit maturity.
"That kind of overconfidence can really hurt investors," Evan Friedman, vice president and senior covenant officer at Moody's, said in an interview. "You in some sense should be thinking about how things look in 2022. You're trading away any kind of negotiating room you might have with the company when they otherwise might have to come back to you and get permission to take certain actions."
Junk-grade companies are taking advantage.
In a typical month, so-called high-yield lite junk bonds account for about 20 percent of total issuance of companies that Moody's covers, according to Friedman. However, since September, the total has been closer to 40 percent, with February's at a robust 46 percent during the same month when covenant weakness peaked.
When "investors look to a covenant package to restrain the activities of the issuer and thus protect the investors, those restraints will not be there," Friedman said. "All of these things can jeopardize the ability of the issuer to meet their goal in the investor's eyes, which is repaying the bond at maturity."