Speculative-grade issuers took advantage of excess liquidity and a continued chase for yield to place record-setting volumes of debt in the first half of 2014.
U.S. and European junk companies paid all-time low rates, while also achieving looser covenants and longer tenors.
The Fed and regulators took note, flagging lax lending standards and complacency in high-yield and leveraged loan markets.
“Signs of excesses that could lead to higher future defaults and losses have emerged in some sectors, including for speculative-grade corporate bonds and leveraged loans,” said the Fed in a report published July 15.
A measure of the strength of U.S. junkbond covenants fell close to the weakest since Moody’s started tracking it in 2011.
“It’s about as extreme as it gets,” Martin Fridson, money manager at Lehmann, Livian, Fridson Advisors, told Bloomberg News. Fridson estimated in July that yield spreads were about 2 percentage points too tight. “Yields are so skimpy and we are in a period of financial repression.”
Investors who ignored the warnings – particularly those buying lower quality assets – were rewarded with the best returns in U.S. debt since the financial crisis.
Bonds of companies worldwide generated gains of 5.4 percent in the first half, BAML indexes show. Debt rated CCC and lower returned 6.0 percent, or 12.8 percent annualized.
The April bankruptcy filing of Energy Future Holdings – the biggest ever LBO – failed to diminish buyside demand for deals to fund new LBOs. Investors also lapped up PIK toggle notes, dividend recaps and second lien loans.
Covenant light accounted for more than half the total U.S. loan issuance for the first time. Also boosting loans, CLO issuance jumped 30 percent year on year to $60.5 billion.
In U.S. high-yield bonds, issuance exceeded last year’s record-setting pace, with $178 billion sold in the first half. As in prior years, the bulk of U.S. bond proceeds were used for refinancing, while acquisition financing saw a big year-on-year jump, albeit from a low base. As more underwriters entered the market, the average reported fee was 1.18 percent, down from 1.33 percent in 2013.
In Europe, high-yield bonds set a new issuance record in the first half, boosted by refinancing and M&A as well as supply from periphery countries like Italy. Sales are on track to set a new record, according to Moody’s in a July 16 report.