Your regular reminder that credit risk is above zero

Something odd is happening in the credit market, as UBS points out today: One narrow set of investment-grade bonds are yielding more than a group of junk bonds.

As a general rule, that shouldn’t happen. Investors typically earn higher yields in the junk-bond market, as a form of compensation for the higher probability of default.

So how to explain it? Well, we’re talking about bonds maturing in 10+ years, issued by companies with the lowest credit rating in the investment-grade category (the worst of the good credits). They yield more than the bonds rated one tier below them (the best of the bad credits), which have an average maturity of seven years.

Comparing the two is a bit tricky, since the bond maturities don’t match up. More on this shortly.

But even so, this occurrence is historically rare, according to the bank:

Because the maturities don’t match up, the yield differential could reflect a couple of things.

It could be a case of improper market valuation, as UBS argues, as investors avoid long-term debt and the higher interest-rate risk that comes with it. Or it could be a supply issue — risky companies could be issuing bonds with shorter maturities than before. This is what happened ahead of the 2013 taper tantrum, according to IFR.

Still, issuance reflects demand, so both options support the analysts’ main point, and explanation: As the Fed raises rates, bond investors are far too worried about interest-rate risk (duration), and not worried enough about credit risk.

UBS isn’t sure that can last, especially as spot crude-oil prices fall below $43 a barrel:

US high-yield has notably more energy & mining exposure (21% vs. 13%), and consumer discretionary exposure (14% vs. 7%) than US investment-grade…
If 12-month forward WTI settles in the $40-45 range, we would expect a sharper selloff in HY energy as break-even levels are breached.

They continue:

There are perhaps nascent signs of fatigue already building. High-yield spreads are effectively unchanged since February. This is in contrast to an equity market that continues to register new highs. HY energy spreads have widened as lower oil prices increase default risks. And US CCC spreads have started to wobble as well (Figure 1), widening 50bps over the last 3 weeks…

The analysts say a big event like a surprise corporate tax cut could prove them wrong. High-yield bonds could also outperform if a big new group of investors (like insurers) starts buying.

But for now, they recommend long-duration investment-grade bonds over high yield, or purchasing put options on high-yield ETFs.