InvestmentsOct 24 2014

US high-yield ‘bubble’ is deflating

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The so-called ‘bubble’ in US high-yield bond markets is deflating, although it is not set to burst, according to a respected economist.

John Higgins, chief markets economist at Capital Economics, has warned there is likely to be further pain to come for high-yield investors after an increase in credit spreads recently led to capital losses.

He said the valuation bubble would not burst, but instead would probably keep deflating “in due course”.

The spread on US high-yield bonds, which is the difference in yield relative to US government bonds, has risen substantially in recent months.

Investors have been spooked by a deteriorating global economic outlook and worries about a lack of liquidity in the high-yield bond market.

The spread between high-yield bonds and government bonds has widened from 320 basis points in June to approximately 430 basis points.

However, even following this move, the spread is still significantly lower – nearly 100 basis points – than the historic average in the past 25 years, although that average includes the very high spreads seen during the financial crisis.

Mr Higgins said: “The bubble in US high-yield corporate bonds appears to have partially deflated since the summer. But we expect it to let out some more air over the next year or two.”

He said while the spread had “risen quite substantially”, once support for the economy had been removed by the US Federal Reserve, he “would not be surprised if the spread rose further”.

“Aside from the fact that the spread is still quite depressed by the standards of the past, the collapse in its level since the financial crisis resulted from the Fed’s expansionary monetary policy, which nurtured investors’ appetite for risk,” he said.

“As policy becomes less accommodative, this appetite is likely to wane.”

But Mr Higgins said it was unlikely the spread would “surge” because during previous monetary tightening cycles the spread between high-yield bonds and government bonds had only widened on average by 10 basis points.

The main danger for high-yield investors is that this widening spread is likely to also coincide with a corresponding rise in the yield on US government bonds.

Mr Higgins has predicted the 10-year US government bond yield will rise from the current 2.2 per cent to 3.75 per cent at the end of 2015.

Given that the value of bonds is inversely correlated to the movement in the yield, a rise in government bond yields will lead to a rise in the yield on high-yield bonds, causing current investors to suffer a capital loss.

One positive for high-yield bonds, according to Mr Higgins, is that they should not be affected negatively by US economic growth.

“A significant deterioration in the economy would be more likely to drive up the spread than Fed tightening, given that the performance of corporate bonds tends to ebb and flow with the business cycle,” he said.

“Yet we forecast healthy GDP growth of 3 per cent in both 2015 and 2016,” he added.