US High yield bonds heading for bubble territory: indicator

A new bubble indicator shows signs that high-yield bonds in the US are going into bubble territory, as their yields breached record lows

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Analysts at RBS launched a Junk Bubble Indicator, which shows that a bubble in high-yield debt is forming in the US, but not in Europe, where high-yield bonds still offer some value to investors.

Alberto Gallo, Head of European Macro Credit Research at RBS, said that the Junk Bubble Indicator looks at four signs of a bubble, assigning them equal weightings to calculate how close to bubble territory the high-yield bond markets are.

The first sign the RBS analysts are looking at has to do with valuations.

“High yield bonds are very, very high in price, very low in yield, very low in spreads. We look at the spreads of these bonds in the US and Western Europe,” Gallo told Emerging Markets.

The analysts looked at the premium of debt rated BB (immediately below investment grade) over debt rated BBB (the lower category of investment grade) and noticed that, all else being equal, European high yield bonds still offer more premium than their US counterparts.

The analysts also looked at what companies are doing with the money they get as funding, Gallo said.

“This is very clear in the US,” he said. “Corporates are using the leverage for the wrong reasons, from a bondholder’s perspective: they’re using it to pay shareholders, to pay dividends, to do LBOs [leveraged buy-outs], to do buyback activity, M&A.”

“We have basically used the M&A activity in the two regions as another factor.”

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Recent M&A deals such as Warren Buffett’s Berkshire Hathaway announcing that it would buy Heinz, as well as the two debt-backed offers for Dell and Virgin Media are close to pre-crisis levels in terms of size, the RBS analysts noted.

“The third factor is on the demand side and it’s an indication on whether investors are really hungry for high yield and are trying to find yield in the wrong places,” Gallo said.

The use of structured products, such as Collateralized Loan Obligations (CLO), has recovered in the US but not in Europe.

That is a sign of a bubble forming because “you have exhausted all the yield on the value in plain-vanilla instruments,” Gallo explains. “You go high in complexity, you also go high in risk. Per se, this doesn’t determine a bubble by itself, but together with very low valuations and bad fundamentals, it does.”

The fourth factor taken into consideration for the Junk Bubble Indicator has to do with “bad fundamentals,” Gallo said.

The US market has a much higher proportion of triple-C and distressed credits, which now make up over 15% of the market compared with 8% in Europe, according to the RBS research.

“European high-yield firms are generally larger, many are fallen angels, with good access to capital markets and good liquidity,” the RBS analysts said.

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