March 20, 2023

Junk Bonds Grow More Popular and Turn Even Riskier

Companies with junk credit ratings have been increasingly issuing bonds for riskier purposes that could hinder their ability to pay back bondholders.

Demand for junk bonds has touched record levels this year as investors reach for their rich yields, a stark contrast to the meager returns available on Treasury securities and money market accounts. But the voracious demand has allowed companies to easily raise money for things that may actually end up weakening them.

For most of this year, the bond issuers were at the higher end of the junk credit-rating spectrum, and were using the money to refinance old debt at lower interest rates, thereby solidifying their economic footing. That made many analysts feel more comfortable about the flood of new junk bonds.

But in recent weeks, there has been a decline in the average credit rating of the companies issuing junk bonds, to C ratings nearer the bottom of the junk rankings from the BB ratings at the top. And companies have been using more of the proceeds for the sorts of risky projects that were common before the financial crisis and in the go-go days of the 1980s — paying dividends to private equity owners and financing mergers and leveraged buyouts.

Jo-Ann Stores and Petco, for instance, both with junk ratings of CCC, sold a combined $875 million of bonds this month, with some of the money set to quickly leave the companies through dividend payments to their private equity owners. Many analysts say that the practice can hurt the financial health of the companies by increasing their regular interest payments to bondholders without strengthening the underlying business.

“Companies that were having difficulty coming to the market, or who want to be more aggressive, have now gotten the opportunity to do so,” said Kingman Penniman, the founder of a junk bond research firm. “Clearly it’s a disturbing trend.”

The shift is particularly worrying to Mr. Penniman and others because so much of the money going into these bonds is coming from individual investors who may be unaware of the declining credit quality.

Over the first three quarters of the year, retail and institutional investors piled into junk bonds with equal alacrity. The record for junk bonds issued in the United States in a single year was broken on Oct. 18, and now stands at $293 billion, compared with $249 billion in all of 2011, according to Dealogic. But in recent weeks, as the bonds have grown risker, figures from the data company EPFR show that wiser institutional investors have begun to shift money out of junk bonds, as individual investors have continued to pour in. Retail investors added about $2.1 billion to their portfolios in the first three weeks of October, compared with a net outflow of $256 million from institutional investors.

The flows into junk bond mutual funds are pushing the managers of these funds to buy up whatever junk bonds are being issued — even if they worry that the bonds could eventually run into trouble.

“The inflows are forcing people to look at these things, even though they might want to hold their nose,” said Mark Hudoff, a portfolio manager at Hotchkis Wiley, a mutual fund management company.

The most commonly cited reason for the recent surge of risky new bonds is the monetary stimulus program announced by the Federal Reserve in early September. By buying up safer mortgage-backed bonds, the Fed is trying to push investors to take on more risk. This would generally lead to big purchases of stock, but after the financial crisis, stocks still carry a stigma for many investors.

Because bonds, whether investment-grade or junk, do not lose all their value when a company goes bankrupt, they carry a greater aura of safety than a company’s stock, which can be wiped out in a Chapter 11 filing. This year, retail investors have put about $22 billion into junk bond funds, compared with the $8.3 billion that went into these funds in 2011 from all sources, according to EPFR.

Because of the minuscule interest rates being offered on other types of bonds, some analysts say junk bonds still represent a good deal. Even as the interest rates on junk bonds have fallen to their lowest levels ever, the yields on Treasury bonds have fallen even more quickly. The total return on high-yield bonds this year has been 12.8 percent, compared with 9.6 percent on investment-grade bonds and 14.1 percent on the Standard Poor’s 500-stock index, according to the Royal Bank of Scotland.

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