The Dangers of Junk

Accrued Interest thinks that high-yield is a good buy at these levels (a yield of about 10%). The "value proposition," he says, "is relatively simple":

The greatest credit loss rate of the last 25 years was in 2001 at 8.3%. So if the 2001 experience were to repeat itself in 2008, investors would earn 10.08% in interest versus 8.3% in credit losses. Determining the exact total return would depend on the timing of the defaults, but the number would almost certainly be positive.

There are a couple of reasons to be cautious, all the same. For one thing, there's no reason that the price of high-yield bonds shouldn't continue to fall, and the yield rise, even if default rates don't go anywhere near 8.3%. Remember that if yields get so high that junk-rated companies can't roll over their debt - if the junk window closes - then that alone could cause default rates to spike.

What's more, a huge proportion of today's junk market is cov-lite loans, something which didn't exist in the past couple of recessions. Junk loans are generally leveraged loans: debt issued by companies which have been bought by private equity shops. Those shops are ruthless, and they understand the concept of sunk costs: they won't rescue their portfolio companies unless they can makes a high return by doing so.

And yes, they have an alternative: they can strip out all the assets they can lay their hands on, pay themselves an enormous dividend, and then leave the company's carcass to its creditors. That's the kind of behavior which would normally be prevented under the terms of loan covenants - but many of these loans have had those covenants stripped out.

So yes, if you can find old-fashioned high-yield debt, loaded with covenants, from a public company, it might be a good buy. But there could be enormous pitfalls in high-yield more generally.