Icahn warns about the junk bond market bubble
In a recent interview with Fox television program Wall Street Week, activist investor Carl Icahn discussed his opinions on the high yield bond (or junk bond) market. He believes that high yield bonds are becoming more risky than ever.
As shown in the above graph, the high yield bond market has been on a bull run over the past few years, owing to extremely low interest rates. The federal funds rate has been held at 0.25% since December 2008. With interest rates still at record low levels, the higher yields offered by junk bonds continue to lure investors.
Junk bonds balance high yields with increased credit risk
Low-risk US government bonds pay meager interest. While the benchmark ten-year Treasury note yields ~2%, junk bonds of extremely low quality could yield ~10%. This increased yield comes at the risk of default on coupon payments or principal repayment by the issuing entity.
The FINRA–BLP Active High Yield US Corporate Bond Total Return Index offered a year-to-date (or YTD) return of 2.74% as of May 13, 2015. However, the FINRA–BLP Active Investment Grade US Corporate Bond Total Return Index offered a YTD return of only 0.24%.
This difference probably makes high yield exchange-traded funds (or ETFs) such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK) popular among investors, owing to the spread they offer over Treasuries.
Spreads offered by high yield bonds below long-term average levels
As shown in the graph below, the spread between high yield bonds and comparable Treasury bonds are presently below their long-term average level. Icahn also pointed out that the high yield spreads are presently narrow and are expected to widen in the future.
Icahn asserted that if a correction were to occur in the junk bond market, it is likely to be massive. Previously, banks could engage in proprietary trading of various asset classes using their own funds. However, Icahn added that the Volcker rule prohibits such investment activities, lowering the liquidity in the markets and making the associated price corrections more severe.
As we detailed in our article High Yield Debt Issuers Return to Market after a Subdued Week, The Chemours Company, a subsidiary of DuPont (DD), recently issued $2.1 billion in dollar-denominated high yield bonds—the largest of the period. Among other recent deals, HCA, a subsidiary of HCA Holdings (HCA) issued $1.6 billion in bonds. Range Resources Corporation (RRC) issued $750 million in bonds. Boyd Gaming Corporation (BYD) also raised $750 million in high yield bonds, and SM Energy Company (SM) raised $500 million in bonds.
In the next part of this series, we will detail how credit default swaps could be used to insure against long positions in junk bonds.
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