Amid a massive return since the March low, the default rate has nearly tripled from year-ago levels as recovery rates deteriorate. “Kicking the can down the road” as vulnerability grows.

Since the market nadir in late March through the end of August, the benchmark U.S. corporate high-yield index returned an eye-popping 27%, as investors poured tens of billions of dollars into speculative grade corporate bond funds, driving spreads down from 1,100 basis points to a recent low of 471 bps. Not to be left behind, institutional investors reversed their net outflows over the preceding three years and moved $27 billion into the space in the second-quarter alone, “the largest amount allocated to the strategy and the largest rate of flow since at least 2005,” according to data tracker eVestment.

“This is a clear reaction to the expectations of increased opportunities available within U.S. high-yield markets in the wake of the COVID-19 induced economic crisis,” eVestment postulated in a report last month. Yet increased opportunities don’t necessarily come without greater risks. “The trailing 12-month global speculative-grade default rate edged up to 6.4% at the end of August, from 6.2% in July and 2.4% in August 2019,” Moody’s Investors Service points out in a September 9 report. That’s its highest rate of repayment failure in a decade.

Bank of America said most indicators of credit stress show “the high-default phase of the credit cycle is over, and we are firmly in the recovery phase.” Still, BofA’s models point to 6% issuer-weighted and 5.5% par-weighted default rates over the next year.

“There’s a lot of nuance to the current default rates, projections and spread tightening,” says Christian Hoffmann, a portfolio manager on Thornburg’s Global Fixed Income strategies. “Things are not where they should be because of the Federal Reserve’s market intervention.” The Fed, of course, has not just pushed its key rate to the zero-lower bound, but in unprecedented fashion, it also bought high-yield bonds to the tune of $55 million a day in May, the peak month for its purchases, which included high-yield exchange traded funds.

A Fighting Chance for Some, Postponing the Inevitable for Others

The Fed has since “significantly reduced the scale and scope of (its) support for high yield,” Citigroup notes, with daily purchases in August of just $500,000 of direct bond buys, and no ETFs. But investors and issuers were already off to the races, running alongside the monetary authority. From the week ending March 25 to September 9, net inflows hit $64 billion, or 25% of beginning period assets under management, with seven of the eight largest weekly net inflows on record during the period, according to Lipper.

Primary high-yield issuance volumes also broke records last month and year to date. Speculative-grade companies rushed to sell paper at attractive funding rates, with an average new coupon in August of 5.1%, a record low. The Fed-facilitated waves of gross issuance, refinancing and net issuance are on track to hit annual records this year.

Yet the extraordinary support spurring high-yield issuers doesn’t take default risk off the table, Hoffmann warns. While it no doubt gives some companies “a fighting chance, for many distressed borrowers, it just delays a potential bankruptcy filing. When that comes, recovery rates are worse after incurring more debt and postponing the inevitable.”

Indeed, recoveries for high-yield bonds over the past 12 months hit record lows at 14.5%, putting them far below the 25-year average of 40%, according to JPMorgan.

“The Next Wall”

“Broadly, corporates came into COVID-19 with too much debt already on their balance sheets, and while the shock was far worse than anything the market had expected, solving problems by issuing more debt is just kicking the can down the road,” Hoffmann points out. “It makes the system more vulnerable and recoveries even lower when the next wall is hit.”

Disciplined, fundamental research can improve the odds that high-yield and investment-grade investors are sufficiently compensated for taking well-measured risks, particularly at a time of unprecedented Fed intervention, frenetic issuance, manic investor inflows and continued economic uncertainty. “We’re not advocating a risk-on stance at the moment,” Hoffmann says.