Is It a High-Yield Bond Bubble?

Investors have been pouring money into high-yield bond funds, shrinking the yields on the bonds and causing some to say the market is risky and bordering on bubble territory. The New York Times and The Wall Street Journal recently had articles airing the views of pessimists.There’s another view. But as with other assets, the historical data might not apply in the current deleveraging environment in which the Fed is manipulating markets. The recent decline on yields is a sign investors expect the zero interest rate policy to continue and that the slow growth environment will be maintained, keeping default rates low.

One thing to think about the Great High-Yield Bubble of 2012 is that it doesn’t look like a bubble in high-yield bonds. That Nuance bond is trading at around 101.5 today, per Bloomberg, which implies on my dopey math an expected annual default probability of 3.3% – two percentage points above S&P historical BB- default rates.**** That does not sound like a market that is totally blind to the risks of high-yield issuers, or that has put a lot of faith in this-time-is-different-ness. Rather, it sounds like a market that is just really really used to low (risk-free) interest rates and expects them to continue for quite a while. Which they probably will. But if there is heartbreak to come, that’s where it’ll probably come from.