(False) Dichotomy of Yields

“‘It’s pretty eye-opening if you’ve been doing [ratings] for 20-plus years, to see how much more leverage a number of these companies can incur with the same credit rating…there’s definitely some ratings inflation.”
-Greg Haendel, Tortoise (Source: WSJ)

In times where it seems like the facts themselves seem to contradict what is presented as an either-or categorization, it helps to check your premises. Chances are, one of them is incorrect.

Among the most obvious signs of fragility is the investor frenzy for Twitter’s and Restaurant Brands’s junk-rated bonds. What does it say about the corporate bond market if investors are going head over heels to snap up junk bonds? What does it say about their yields?

Junk bond yields at present trade at a far lower rate than where investment-grade used to. Prior to the Great Recession, investment-grade yields traded around 6%. And what was the yield on Twitter’s junk-bond deal? Twitter issued $700 million of 8-year bonds at a yield of 3.875%, matching Restaurant Brands ($750 million, 8-year) making it the lowest for the US HY market. Investor eagerness for that deal and others is after all just another hallmark of widespread complacency.

On the investment-grade side, Deere sold its 30-year bonds at record low yields of 2.877%, while Apple did so for just below 3%. Similarly, Blackstone group reduced its 10-year bonds to 2.5%. In comparing this batch to the HY bonds mentioned, those junk rates are still higher than most investment-grade. However, compared to historical levels, junk bonds should not be yielding rates this low.

To complicate things, what gets counted as investment-grade should, in actuality, be rated as junk. According to Morgan Stanley research, nearly 40% of the investment-grade corporate bond market should be downgraded to junk status based on debt to EBITA ratios. This form of “rate-inflation” leads to perverse incentives, out of purposeful leniency or otherwise. And the consequences? While investment-grade companies are able to keep selling so much debt as investors reaching for yield as the Fed cuts rates, junk-rated companies are struggling.

These camouflaged speculative-grade bonds also explain the burgeoning in BBB rated debt over the past decade, in contrast with the sluggish growth in the HY market. In fact, 50% of all investment-grade bonds are rated BBB, up from 28% in September 2009, and 17% in 2001. In aggregate, BBB debt has grown 227% since January 2009.

In truth, categories aren’t as blatantly clear-cut as they seem.

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