Junk Debt Prices Exude Gloss But Are Hiding Some Dross

(Bloomberg Gadfly) -- Let's say you bought an apartment for $500,000 as an investment when housing prices were rising and the economy looked solid.

The only problem is that a real estate company had the right to buy back the apartment at any time for $495,000, which would cause you to lose $5,000 on a price basis regardless of the market's direction.

This is essentially what's happening in speculative-grade debt markets right now. They have become so frothy that bond buyers are paying prices for debt above where companies are allowed to repurchase it.

Consider the $1.3 trillion U.S. high-yield bond market. About $400 billion of this market is callable in the next year, meaning that companies can decide to pay it back early at a specific price, according to Bloomberg Intelligence. More than 30 percent of that total is trading above that value.

In other words, someone who buys those above-call bonds is at risk for losing money simply because a company decides to exercise its right to repurchase debt. Bond investors are typically aware of this dynamic and are deciding to buy these bonds anyway because they can earn regular interest payments that can offset any sale price decline. 

It's understandable that bond buyers would favor riskier debt at a time of general economic growth and historically low rates. But that picture is slowly changing. The Federal Reserve is raising interest rates, and junk bonds are susceptible to price drops as a result of higher benchmark borrowing costs. This is especially the case as prices climb to levels that significantly suppress future potential returns.

Almost $65 billion of bonds are trading at prices higher than those at which companies may repurchase them this year, Bloomberg Intelligence analysts Noel Hebert and Joel Levington noted on Monday. Some specific bonds that are trading above their repurchase price include those of Restaurant Brands and T-Mobile USA, their data show. 

This is happening in the speculative-grade loan market as well. Companies can choose to reprice these loans at any time, locking in lower rates if there's sufficient demand. And they are doing so at an accelerating pace, with such repricings and refinancings reaching the highest level in the three months ended March 31 since at least 2013, according to Lara Wieczezynski of Bloomberg News.

The fact that a growing amount of debt has such incredibly limited upside shows just how zesty the market has become. Returning to the apartment analogy, it's like buying a property that you can rent out while you wait to see whether the real estate company will repurchase it at a lower price than you paid. You may break even, or even earn a few extra dollars, but your purchase is unlikely to ever be a windfall.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

To contact the author of this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.