Yield signs

High-yield boom enters hold-your-nose territory

The high-yield boom is heading for hold-your-nose territory. Egged on by central banks, bond investors will keep chasing yield, despite a market sell-off, a few blow-ups and rising corporate indebtedness.

By early December, 2014's high-yield issuance exceeded $400 billion, with Europe breaking records at $165 billion, according to Thomson Reuters data. At the end of the third quarter, default rates stood at just 2.1 per cent.

Those volumes hide the fact that 2014 was a turbulent year. From a trough at 359 basis points in June, credit spreads on junk bonds rose above 570 basis points by mid-December, as investors fretted first over the end of US money-printing, then about the collapsing oil price and its effect on emerging markets. A few deals, like Phones4U in Britain, have gone awry.

The market turmoil means junk bonds are no longer screamingly expensive: on Lehmann Livian Fridson Advisors calculations, US junk debt is cheap by roughly 30 basis points. Yet 2015 may bring more challenges, including the first US rate rise. A supply shock could knock prices, as a deluge of Italian and Russian bonds risk falling from investment-grade.

Default rates will probably start rising too. For a start, oil's plunge threatens to hurt many smaller energy firms, who make up 17 per cent of the US high-yield index. Looking further out, it's worrisome that junk bond issuers are increasingly shaky. Issuers with super-low CCC ratings account for 17 per cent of deals, more than in 2007. Historically an average of 41 per cent of these companies default within three years, Standard & Poor's data shows.

On the plus side, Europe's pivot away from bank financing will continue. And with the global economy still fragile, the US Federal Reserve is unlikely to lift rates much. Meanwhile, other monetary authorities will keep policy loose: the European Central Bank plans to buy euro 1 trillion of assets, possibly including corporate bonds. Once again, investors will be forced into riskier credit to get returns.

When central banks eventually get tougher, money will flow elsewhere and increased borrowing costs will test the resilience of the weakest. But don't count high-yield out just yet.