FRBSF Economic Letter
2001-33; November 16, 2001
Rising Junk Bond Yields: Liquidity or Credit Concerns?
Economists and other analysts look for signs of the economy's current
and future performance in many places, including the bond market. One
recent signal from that market that may prove useful involves the spread
in the yields between junk bonds and other long-term debt instruments.
For example, the Merrill Lynch junk bond index has reached its highest
level since the last recession, while investment-grade bond yields remain
fairly low by historical standards. Junk bonds, or speculative-grade bonds,
are rated below Baa by Moody's (and below BBB by Standard and Poor's),
the minimum rating for investment-grade bonds. Junk bonds also are called
high-yield bonds because they carry significantly higher interest rates
to compensate investors for bearing the higher risk that is inherent in
those bonds. A widening in the spread between junk bonds and other long-term
debt instruments may be a useful signal because junk bonds are issued
by firms with marginal credit quality that are more vulnerable to changes
in economic conditions than investment-grade borrowers. This Economic
Letter takes a closer look at the recent increase in junk bond yields,
and, in particular, compares the latest episode to the sharp rise in junk
bond yields in 1998 following the Asian financial crises.
Yield spreads of junk bonds
Like any fixed-income securities, the return from holding a junk bond
is usually measured by the yield-to-maturity, which is the rate of return
for holding a bond until maturity. The junk bond yield involves two components:
the default-free bond yield and the risk premium. The default-free bond
yield refers to the rate of return for holding a similar maturity default-free
bond, which usually is represented by Treasury securities. The risk premium
compensates the investor for bearing the credit risk and the liquidity
risk of the junk bond. Credit risk refers to the possibility that the
borrower will default. Liquidity risk refers to the potential liquidation
cost from selling the bonds in a thin market. In a thin market where potential
buyers are scarce, not only does the bid-ask spread on a security widen,
but also sellers must lower the bond price both to lure buyers into the
market and to compensate them for the heightened liquidity risk. While
the market for Treasury securities is considered very deep and resilient,
hence involving little liquidity risk, corporate bonds have liquidity
risk because each bond issue is relatively small. Moreover, each corporate
bond has unique attributes, so the number of ready buyers for each bond
can be quite limited. Among corporate bonds, junk bonds have more liquidity
risk because their issue sizes generally are relatively small compared
to investment-grade issues. Moreover, many institutional investors, including
pension funds and certain trust accounts, are prohibited from investing
in below-investment-grade securities, further limiting the pool of potential
investors.
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To isolate the junk bond risk premium from pure interest rate movements,
Figure 1 charts the yield spread between the Merrill Lynch junk bond
index and 7-year constant maturity Treasuries since 1986. Although the
available data span only one business cycle, the figure suggests that
the junk bond risk premium rises and falls with the business cycle. Borrowers'
ability to service their debt obligations, particularly marginal borrowers,
is usually higher during economic expansions than contractions. So, during
expansions, credit risk tends to be lower and, hence, the yield spread
tends to be narrower, while the reverse tends to hold during slowdowns.
In Figure 1, the yield spread for junk bonds jumped 258 basis points
from January 1989 to June 1990, just before the economy entered the recession.
Thus, the run-up in the junk bond risk premium in 1989 and early 1990
was consistent with the rising credit risk concerns at that time.
The liquidity shock in 1998
Between June 1998 and October 1998, the junk bond risk premium rose 334
basis points, but no recession followed. Rather, the increase in risk
spreads appears to have been tied to turmoil in financial markets. Around
mid-1997, the Asian financial crisis began to unfold, culminating in the
Russian government's default on its sovereign debt in October 1998. This
led to the seizing up of the credit market and the near collapse of the
hedge fund, Long-Term Capital Management. At that time, the large degree
of uncertainty in the credit market made it very difficult to liquidate
risky bonds, as potential investors exited the corporate bond market in
favor of the default-free Treasury market. It appeared that the lack of
liquidity in the corporate bond market was the driving force behind the
yield rise in 1998.
To see more clearly how a liquidity shock drives junk bond yields, it
is useful to look at the comovement in bond yields. The comovement in
bond yields should be high in response to a liquidity shock, because it
is a systemic event that can be expected to have a similar qualitative
effect (though different quantitative effect) on corporate bonds across
the risk spectrum. In contrast, when changes in bond yields are driven
by changes in the credit quality of the borrowers, the movements in bond
yields would be expected to respond to the idiosyncratic shock of the
borrowers, implying that the comovement in bond yields is expected to
be lower.
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To illustrate this, Figure 2 shows the covariance between the change
in Moody's Aaa rated-Treasury spread and the change in the junk bond-Treasury
spread since 1990. During the 1990-1991 recession, the comovement in the
Aaa-rated and junk bond yield spreads rose in response to general deterioration
in the economy, but it took more than a year before the rising covariance
peaked. In contrast, in 1998, the comovement in yield spreads rose sharply
in August and peaked in just three months. This suggests that the movement
in yield spreads in 1998 was consistent with a systemic event, namely,
the lack of liquidity in the bond market.
Nevertheless, a systemic shock also may worsen the credit quality of
many borrowers, leading to a widespread increase in credit risk premiums
and thus a high level of comovement in risk spreads. To distinguish between
liquidity shocks and credit risk shocks further, it may be useful to look
at the relation between stock and bond prices. Absent changes in liquidity
constraints, movements in bond yields reflect the bond market's assessment
of the borrower's creditworthiness. Since many borrowers in the junk bond
market also issue publicly traded stocks, the stock market also is continuously
assessing the future prospect of the borrowing firm. Kwan (1996) shows
that there is a strong relation between changes in the bond yield and
the borrowing firm's stock returns, particularly among junk bond borrowers,
as both stock and bond prices generally are driven by the same firm-specific
information.
In the case of a general liquidity shock, however, movement in risk spreads
may be less tightly linked with firm-specific developments, as evidenced
during the 1998 financial market turmoil. For example, consider the performance
in four sectors: telecommunications, technology, energy, and health care.
Between November 1997 and October 1998, the risk spread for junk bonds
in telecom, technology, and health care sectors rose between 100% and
130%. Despite the similarity in the changes in bond yields, the stock
price performance for these three sectors was quite different. The average
annualized stock returns for junk bond issuers in telecom and technology
were positive, at 17.8% and 131%, respectively, while those in health
care were negative, at -55%. The energy sector saw the largest relative
rise in junk bond spreads, at 233%, even though the issuers' average stock
return, at -30.5%, was higher than those in the health care sector.
The apparent disconnect between the pricing of the debt and equity of
junk bond issuers during 1997-1998 suggests that the rise in junk bond
risk spreads was not entirely driven by changes in firm-specific fundamentals.
Rather, it was more consistent with a general shift in liquidity preference
among investors.
Putting recent movements into perspective
Before the terrorist attacks on September 11, the yield spread of the
Merrill Lynch junk bond index had risen more than 300 basis points since
the beginning of 2000 (Figure 1). This was accompanied by a gradual increase
in the comovement of bond yield spreads. These patterns seem to suggest
that before the attacks, the run-up in junk bond spreads was driven by
concerns about rising credit risk. However, following the attacks, the
spread skyrocketed almost 200 basis points to 968 basis points, just 46
basis points shy of the peak recorded during the 1990-1991 recession.
While there is no question that a large part of the rise in junk bond
yields reflects investors' reassessment of credit risk, the comovement
in bond yield spreads, shown in Figure 2, shot up to a level not seen
before. Both the rate of the increase and the level of comovement in yield
spreads after September 11 indicate that some of the sizable jump in yield
spreads may be attributable to the limited liquidity in the junk bond
market.
Of the four sectors examined earlier, between January 2000 and August
2001, junk bond spreads in the energy sector had risen only 21% (or 100
basis points) while spreads in the health care sector had actually declined
15% (or 56 basis points). This reflects the positive developments in these
two sectors, as evidenced by the 48% one-year return on energy stocks
and the 70.5% return on the health care stocks of the junk bond borrowers.
During that time, junk bond investors clearly were discriminating between
good and poor performers as judged by the stock market. The junk bond
spread rose 225% (1129 basis points) in the telecom sector and 116% (553
basis points) in the technology sector. The one-year stock returns of
the junk bond borrowers in the telecom sector and the technology sector
were -57.4% and -72.5%, respectively. This further suggests that the increase
in junk bond yields before the attacks was driven by credit concerns about
specific companies, most notably telecom firms and technology companies.
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After the terrorist attacks, the widening of risk spreads on junk bonds
was evident in most sectors, but especially among firms in the air travel
and tourism industries. Figure 3 shows changes in risk spreads based on
Merrill Lynch's index for firms in 16 sectors with junk bonds outstanding,
from September 10 to October 10, 2001. While investors are reassessing
the credit risk of different borrowers in different sectors as a result
of the attacks, the fact that all sectors among junk bond issuers show
some increase in risk spreads suggests that a deterioration of liquidity
in the junk bond market may have exacerbated borrowing costs.
Conclusion
Junk bonds provide financial market signals about current and future
economic activity because their yields reflect the market's assessment
of the credit prospects of the borrowing firms, whose marginal credit
quality is highly sensitive to changing economic conditions. However,
in addition to credit concerns, junk bond yields also are driven by systemic
factors, among which the level of liquidity in the bond market is perhaps
the most important. In interpreting junk bond yields, it is necessary
to separate the systemic factors from the idiosyncratic factors. Before
September 11, the run-up in junk bond yields in 2001 seems to have reflected
specific credit concerns about the borrowing firms, as firms whose stocks
were performing well generally did not see their junk bond yields go up,
and the comovement in bond yields was not that high. After September 11,
the sharp rise in junk bond yields clearly reflects the heightened credit
risk of the borrowers. At the same time, the comovement in bond yields
spiked up to a level not seen before, suggesting that deteriorating liquidity
in the junk bond market may have pushed borrowing costs up further.
Simon Kwan
Research Advisor
Reference
Kwan, S.H. 1996. "Firm-specific Information and the Correlation
between Individual Stocks and Bonds." Journal of Financial Economics
40, pp. 63-80.
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