Here They Go Again: Fund Managers Chasing CCC Debt Right Into The Next Default Derby

There are three layers of triple C debt in the S&P rating system including CCC+, CCC and CCC-. Those notches happen to stand for “substantial risks”, “extremely speculative” and  “default imminent with little prospect for recovery”.

Between 1981 and 2008 the average default rate on this bottom of the barrel paper was 23% and in periods of economic dislocation and recession it was much higher. Default rates on CCC/C debt in 1991 peaked at 34%; reached 45% in 2001; and topped out at 58% in 2008!

Yet as detailed below, there is now a mad scramble into CCC debt by money managers searching for yield. And what compensation are they getting for the virtual certainty that during the next financial crash and economic recession there will be deep, double digit losses on this crappy paper?

The answer would be exactly 8.187%, which is to say, they are guaranteed to experience large losses based on three decades of history.  What are the PMs who run high yield funds possibly thinking?

Sadly, that question is not hard to answer. They are thinking that this time is different; and, besides, they are nimble and smart enough to get out of the way in front of the herd if anything should go wrong.

Yes, that’s exactly what previous generations of high yield managers said in 1991, 2001 and 2008. Some of them are now in the house painting business, and appropriately so.

But there is a larger point. The serial bubbles generated by the Fed and the other central banks are like the World War I drafts. Eventually the new recruits ended up as cannon fodder in the trenches, but there was always another fresh wave to replace them—at least for the better part of a half-decade.

In an honest free market the recruitment drives of bubble finance would not go on for 4-7 years—only to end in a quick, violent demise. The giant risks embedded in CCC debt would be properly priced in the first instance. That is, most of it would never be issued because there wouldn’t be any buyers at yields that debt-besotted companies could afford.

A recent Wall Street Journal story provides more details on the current scramble of the lemmings.

Large investors are rushing into the riskiest corporate bonds, frustrated by low interest rates on safer investments and convinced that even companies with shaky finances are in little danger of default.

One sign of that rush: Investors have been buying up corporate bonds with a triple-C rating, a grade that analysts and investors consider highly speculative.

That buying is driving up prices on those bonds and pushing down their yields, which this month fell to 8.187% on a closely watched Bank of America Merrill Lynch index—the lowest level on record. 

This embrace of risky bonds and the retreat from risky stocks reflect a world where interest rates are staying much lower, much longer than most had expected, some investors say. “What we’re seeing is the continued search for yield,” says Matthew Rubin, director of investment strategy at Neuberger Berman, which oversees $247 billion.

The 12-month trailing default rate from low-rated corporate borrowers edged up to 1.7% in April, from a six-year low of 1.57% in March, according to Standard & Poor’s Ratings Services.

The yield gap between junk bonds and U.S. government debt—a measure of the premium investors receive for taking on the risk of junk bonds—has narrowed. On triple-C-rated debt, that gap recently hit 6.97 percentage points, the lowest since November 2007. The all-time low of 4.14 percentage points was hit earlier that year.


Full article here.