In the autumn of last year, US bond investors fully expected Cloud Peak Energy to pay back the money it had borrowed. A bruising fourth-quarter sell-off across commodities has since put that in doubt, as the Wyoming-based miner has missed a series of interest payments.
Elsewhere, adhesives business Hexion, backed by private equity firm Apollo Global Management, slipped into bankruptcy this month with $2.5bn of its $3.8bn debt load maturing in 2020.
What both companies had in common: they are rated triple-C, one of the lowest rungs on the ratings ladder.
“I think of triple-C bonds a little bit like the bar scene in Star Wars,” says Scott Roberts, head of high yield at Invesco, evoking a port described by one character as a “wretched hive of scum and villainy”. Mr Roberts adds: “Every single one is unique. You have to understand that because they can wreck not just one but multiple years of your performance. It is the greatest source of default activity.”
That level of risk is proving too much for many investors.
Even as the Federal Reserve has eased concerns over an imminent recession by softening its policy stance, boosting assets from stocks to commodities and prompting other central banks to follow suit, some of the riskiest debt in the US is still struggling to find support. Investors, scarred by the precipitous fall in credit markets at the end of last year, remain cautious about funding companies considered to be on the brink of default.
During the first quarter, 8.2 per cent of triple-C rated corporate bonds delivered a loss of at least 10 per cent, according to Citi. Slightly more than 5 per cent lost 20 per cent — only a slight improvement from the brutal fourth quarter of 2018.
Overall, US triple-C and lower-rated bonds have returned just over 10 per cent this year, slightly outperforming the broader high-yield market that has returned around 9 per cent, according to indices run by Ice Data Services. This might sound like good news, but the riskiest companies are expected to fall furthest in a downturn on the presumption that they will be the first to default. Conversely, they are expected to rise more dramatically as the prospect of turmoil subsides.
Triple-C debt returned a loss of 9.6 per cent in the fourth quarter, compared with just 4.7 per cent across the whole of high yield. Citi estimates that based on historical price movements, the bonds should have returned 14.6 per cent this year.
In reality, returns have only just managed to inch above the broader market. Money has flowed into the bond market this year but not all debt issuers have benefited.
“What it boils down to is that investors are willing to take some risk to get a higher yield in the continued low interest rate environment but they are showing some residual signs of caution for the most risky companies,” says Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors. “There is some awareness that going into the very riskiest corners of debt markets is not a good idea right now.”
The new sense of caution stands in contrast to the “reach for yield” that has characterised much of the post-crisis period, and which carried through for much of 2018. For the first nine months of the year triple-C bonds returned 6 per cent, compared with just 2.5 per cent for the broader market. But then the game changed.
“Last year showed investors how you could get burnt being invested in triple-C bonds,” said Michael Anderson, a strategist at Citi. “Investors don’t want to be part of that again. There is some acknowledgment that we are not completely out of the woods and it’s better being in credits that you are completely confident in.”
So far in 2019, the ratio of ratings downgrades to upgrades is the worst since the energy crisis in 2016, according to S&P Global, a rating agency, even if the actual number of companies defaulting remains low.
Industries in the grip of rapid transformation are most vulnerable, say analysts at Citi. Traditional bricks-and-mortar retailers, for example, have come under pressure as online rivals continue to alter the way people shop. Energy companies are also wrangling with their business models and balance sheets as they try to strengthen protections against lower commodity prices. Healthcare remains a political battleground, too.
But despite all this, some investors remain sanguine, arguing that prolonged support from the Fed should keep many borderline companies afloat.
“If your expectation is that a recession is six to nine months out then you should be going up in credit quality but if you think the dovish tilt of the central banks has extended the cycle — which we do — then you don’t need to be defensive,” says Bob Michele, chief investment officer at JPMorgan Asset Management.
“In fact, you should be going down in credit quality.”