'Dash for trash' as investors move out of risk spectrum

The “dash for trash” is on, as the near-record low yields available on safe assets has prompted investment professionals to move further out of the risk spectrum in a desperate bid to earn nominal returns that satisfy client needs.

Cautious optimism persists among buy-side commentators, but actions speak louder than words, and market movements suggests investors are behaving quite differently than their rhetoric, as robust demand continues to outstrip supply and push the yields on lesser-quality bonds ever lower.

The resulting valuations confirm that a substantial part of the market for fixed income securities has entered the speculative phase of the credit market cycle.

It was all so different not so long ago, as the bullish complacency apparent at the height of the credit bubble, turned to all-embracing fear following the collapse of Lehman Bros.

The first tremors of what would soon become the worst financial crisis in 70 years erased the irrational exuberance evident in the prices of risky debt, but the failure of a major investment house proved lethal; the credit markets ceased to function, as forced selling – and the resulting illiquidity – pushed yields to unfathomable levels.

Extreme risk aversion prompted investors to flee the market for corporate credit en masse, which saw investment-grade bonds suffer double-digit losses in a matter of weeks.

The carnage in high-risk segments was far more punishing, as the spike in the yields of junk bonds to more than 20 per cent resulted in losses of some 45 per cent for their unfortunate holders.

All told, the default rates implied by the yields available on even the highest-quality credits moved to levels that were without modern precedent, and savvy investors could bank on equity-like returns with bond-like risk.

Credit-easing policies

Of course, outsized rewards could be expected if, and only if, the Bernanke-led Fed’s unconventional monetary policies could unfreeze the markets, and return risk appetite to more normal levels.

Near-zero interest rates, in tandem with credit-easing policies, proved successful, and the spread on lesser-quality credits versus default-free Treasuries dropped from a peak of more than 6 per cent at the end of 2008 to below 3 per cent just eight months later, as investors priced out an economic and financial apocalypse. Fed policy ensured a quick return to “business as usual” on Wall Street.

Corporate bond pricing may not seem excessive to many on first glance. After all, the credit spreads on lesser-quality corporate bonds have made little progress in the past three years, hovering around

3 per cent for most of that time, while current spreads are more than one percentage point above the lows registered at the height of the credit bubble. This observation has seen many buy-side commentators argue that the bull market has further to run.