The credit markets are no place for discerning investors these days. US junk bond and leveraged loan sales have surpassed $1 trillion in 2021, an unprecedented amount for a calendar year. Loan funds have experienced inflows during all but two weeks this year, bringing the S&P/LSTA Leveraged Loan Price Index close to an all-time high, and year-to-date issuance of collateralised-loan obligations is also at a record. Even municipal-bond buyers are turning to the riskiest corners of the market, plowing $1.2 billion into high-yield muni funds, data from Refinitiv Lipper show.
Simply put, in the world of corporate credit, many companies want to borrow cheaply and a lot of investors are all too willing to lend at rock-bottom rates. This is hardly a new phenomenon, but with signs of deal fatigue finally creeping in ahead of the Thanksgiving holiday and a more subdued December, it’s worth taking a step back to assess the bond market. When scanning the market, it quickly becomes clear that thanks to the Federal Reserve’s unprecedented intervention in March 2020, combined with its steadfast willingness to tolerate a longer-than-expected stretch of elevated inflation, investors see little choice but to whistle past the graveyard. Risks may be piling up, but haven’t you heard? Distressed debt is dead. In fact, the rampant borrowing hasn’t kept pace with a surge in spending and higher prices: Junk-rated companies have the least debt relative to earnings since 2015.
Indeed, with healthy balance sheets across the board, it has clearly paid off to lock in any sort of credit spread in 2021. The Bloomberg US Treasury Index has lost 2.75% so far this year as yields gradually climbed from their pandemic lows. Investment-grade corporate bonds have fared slightly better, dipping 1.6%. But it’s junk bonds, which have gained 4.4%, and leveraged loans, which are up almost 5%, that have been some of the best performers in the public markets.
All the while, Bloomberg News’s credit reporters have been doing an admirable job of flagging the mounting risks, even if the relative performance suggests traders don’t seem to care. Of course, this sort of erosion in investor protections happens during every period of risk-taking. But this cycle might go even further. Bloomberg’s Natalie Harrison reported that private-credit funds, which are much better positioned than public market investors to demand safeguards in return for often being the sole lender on a deal, are increasingly throwing in the towel and agreeing to “covenant-lite” structures as well. Individual and institutional investors alike are rushing to get into the illiquid credit market as an alternative to otherwise paltry corporate-bond yields.
At the same time, private equity firms are piling a record amount of debt on to portfolio companies as a way to pay themselves large dividends. In one of the most extreme examples, Lottomatica SpA, bought by Apollo Global Management Inc in May, priced a 400 million-euro ($462 million) bond at 8.125% earlier this month, with proceeds earmarked to pay such a large dividend that Apollo will effectively recoup its entire investment. That kind of quick return is increasingly important when private equity giants are raising an unprecedented amount of cash, leaving them “in a state of collective delusion” and paying deal multiples that look “bananas” to beat competitors for acquisitions.
Few would argue that these kinds of maneuvers, fueled by cheap financing, are a healthy development for the broad financial system. Yet it comes back to that gnawing question for investors: What’s the alternative? The average US junk bond yields 4.38%, which is now lower than inflation, whether measured by the consumer price index or the personal consumption expenditures index. It’s even worse for buyers of investment-grade credit.