(Bloomberg) – Junk bond guru Marty Fridson warns that investors chasing high yields on U.S. corporate bonds are not adequately compensated for their risks.
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“Investors are systematically overpaying for industries that offer higher-than-median yields,” Fridson, who has studied debt analysis on Wall Street for decades, said in a report Wednesday. said. He added that bond buyers “have inferior risk-adjusted returns.”
Fridson’s analysis points to growing dangers beneath the surface in the high-yield bond market, where the bullish consensus is supported by expectations for strong U.S. economic growth. Junk spreads fell this month to their narrowest since early 2022 as investors raced to lock in historically high Treasury yields before further easing from the U.S. central bank begins to erode returns.
The surge in demand and lack of supply has led to riskier borrowers entering the market, such as dividend loans and deals that can be repaid with new debt, and credit risk may not have been properly assessed. There are growing concerns that this may be the case.
Fridson said competition for investment funds is forcing mutual funds to pursue higher yields. But illiquidity and default risk are often not adequately considered, said FridsonVision High Yield Strategy’s CEO.
In a perfectly efficient market, credit returns should vary with the level of potential decline. But when Fridson looked at corporate bonds by sector going back nearly 30 years, he found that industries with higher yields also had lower risk-adjusted returns, as measured by the Sharpe ratio.
If buyers are rational, the difference in risk-adjusted returns should direct capital to better borrowers and eliminate the gap. But Fridson said that while telecom sector bonds offer higher yields than aerospace bonds over the long term, they come with much higher volatility and risk, and similar differences can be seen in other industries.
“Empirical analysis reveals that tracking is the culprit,” Fridson wrote. From 1997 to 2003, the aerospace industry had an average return of 61% higher than telecommunications, with a standard deviation of 44% lower, he added. “An investor with perfect foresight would have thought aerospace was a good industry to be overweight.”
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The high-yield bond market has seen further increases in prices over the last month, Fridson said. According to Fridson’s analysis, the junk spread should be 486 basis points (288 basis points as of Tuesday’s close), taking into account general credit usage, economic indicators, default rates, Treasury yields and quantitative easing. That’s what it means.
“High yields are clearly rich at this point,” he wrote.
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