The demand for one of the riskiest forms of corporate debt in the United States is experiencing a resurgence this year. Companies are responding to investor preferences for assets capable of securing elevated yields over multiple years, especially in anticipation of forthcoming interest rate decreases. This trend is contributing to the revitalization of the $1.4 trillion global junk bond market, as businesses seek to stave off potential distress during economic downturns. However, it’s also exacerbating the divergence between the highest and lowest-rated bonds in the market, potentially heightening the risk of defaults.
The average yield on new investment-grade corporate bonds has dropped 36 basis points since the Federal Reserve’s last meeting, lowering expectations for interest rates’ future path. At the same time, yields on bonds rated double-B, which make up half of the overall junk bond market, have fallen to their lowest level in more than two months.
That has allowed borrowers with weaker ratings to borrow money at lower prices, and some investors have been willing to take on the additional risks of investing in those bonds. Consequently, the share of bonds in the B-tier of the junk rating system, considered junior subordinated debt, has risen to nearly the same level it reached at the end of 2021.
Holders of those bonds, which are considered subordinated to senior debt and preferred stock, will only be paid in case of a company’s bankruptcy or default after more senior debt holders are repaid. As a result, they often carry higher interest rates than senior debt. Those bonds are also usually not backed by any form of collateral.
Junior subordinated bonds are typically issued in tranches that are repaid at different times, based on the priority of their repayment process in a bankruptcy or default scenario. For example, the z-tranche of the bonds issued by energy transport company Energy Transfer ET.N is repaid first, followed by the y-tranche and then the x-tranche of the debt.
The high-yield debt market has been particularly active in the first quarter of this year as companies seek to tap it to finance projects such as expansions or acquisitions. The share of debt sold by investment-grade companies has risen to a record high, while the supply of junk or “speculative-grade” bonds has jumped to its highest level in over two months. That has been fueled by a combination of factors, including the Fed’s signaling that it is in no hurry to cut rates. It is also a function of tightening credit spreads, which is the premium investors pay to lend to lowly-rated borrowers over Treasuries. That is why investors have been snapping up those hybrid bonds. They offer higher yields than investment-grade bonds but are less risky than stocks. Their tax-deductible status further boosts investors’ hunger for the securities. That has led some companies to use them to refinance taxable preferred shares that are coming due.
