High-yield bond bonanza

0:05Pushkin. Corporate bonds, debt issued by companies, they're red hot right now. Investors are piling in at a record pace. Today on the show, why? This is Unhedge, the markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu here in New York, joined from London by the silhouette of Katie Martin. Yeah. How are you doing, Katie? I'm good. Listeners may not understand that though, Ethan, but I am sitting in a darkened room. It's just the light has broken. So I do look a bit odd on the screen that Ethan can see me on, but I am here. Katie was absolutely blinded by the lights in the London studio, which I guess were brighter today than usual.

0:49And she was like holding up her hands to guard her eyes from the harsh lights. Yeah, it's like, you know, that thing where there was the NFT kind of festival in Hong Kong, and they put up the wrong kinds of neon lights and a bunch of people went temporarily blind. It was like that, but without the NFTs. Something else that is so hot and scouting that is burning my eyes out. It's corporate bonds, Katie. The market is absolutely roaring. And I think to talk about what's going on in that market, we have to do some terminology because unlike stocks, I think this is a market that gets maybe a little bit less attention and has terminology that people maybe are a little bit less familiar with.

1:31So we talk mostly about treasury bonds, right? Bonds issued by usually the US government, but we talk about gilts in the UK and other sovereign bonds. That's not what we're talking about today. Today, it's corporate bonds, when a company goes to the market and issues some paper. Yeah, when they basically issue IOUs out to the market, and so fund managers can buy them, they are guaranteed a certain rate of return through what we call a coupon. And that translates into a certain overall rate of return, where you kind of mix up the price at which you buy the bonds and the level of the coupon and you get what you call a yield.

2:08And a lot of this is stuff that most people don't need to know. But the point is that for people who are holding these bonds and people who are buying new bonds that hit the market, it's really quite lively out there. And one thing about the corporate universe is there are a lot more companies than there are governments. So there's a lot of different levels of company financial stability. Also kind of like governments. You do want to lend to the US. You don't want to lend to Argentina. Similarly, you probably do want to lend to Apple or Microsoft, but maybe you're kind of iffy about lending to that brand new tech startup that's sort of on its last legs.

2:44And so corporate bonds, broadly speaking, are grouped into two universes of creditworthiness. You've got your so-called investment grade bonds. That's your kind of blue chip, rock solid companies with a very low history of defaults on the bonds. And then you have your so-called high yield or also known as junk rated. And that's your companies that are maybe a little shakier, have a little bit more default history, or their balance sheets don't look so healthy, or they've had some bad quarters recently, or something along those lines. And there's lots of gradations within those two categories. But broadly speaking, when you talk about corporate bonds, there's two big universes, investment grade or IG and high yield.

3:21Perfect. No notes, Ethan. That's exactly it. Locked and loaded. Well, now that we have some of the kind of terminology set up, both of these markets, IG and high yield are going absolutely bananas. And you can see that across a variety of metrics, right? You see that in terms of issuance, like the amount of bonds that companies are putting out there on the market. You can see it in terms of investor demand, like how many of those bonds are getting snapped up. You can see it in terms of valuations, like where the bonds are actually trading on the market. And in sort of all those dimensions, there's a lot, a lot, a lot of appetite out there for corporate bonds.

3:55Yeah, I found it a bit weird, right? So I've been talking to a few debt capital markets bankers. These are people who bring new corporate bonds to market. And I said, you know, I find this quite odd because I would have thought that companies would wait until benchmark interest rates fall and make it cheaper for them to borrow. And they would just borrow towards the end of the year and they would try and lock in cheaper borrowing costs then? And they say, no, no, not at all. Because the amount of demand that we've got from investors who want to lock in reasonably higher yields now is outweighing that.

4:30And so there's so much demand out there for this paper that companies are saying, okay, fine, whatever. We'll go now. We won't wait until the summer. I mean, the environment, as we've talked about the show a little bit, it's sort of unreal, like how good it is for a certain type of investor, right? You have the latest GDP tracking estimates are like 4 % plus. Absolutely, absolutely roaring. Yeah, we're coming around to this new kind of worldview that we spent the past 12, 18 months, it feels like forever having this endless debate about, oh, will we get a soft landing or will we get a hard landing?

5:02And the economic data at the moment is saying to us, guys, maybe there's no landing. Maybe this is fine. Maybe inflation just comes down and growth stays pretty robust and nothing bad happens and nothing breaks. That's kind of weird. That's not how we're all told that the world works after you've had massive interest rate rises. Absolutely. And so you could get a situation where you have falling interest rates, good for investors, strong economic growth, good for investors, and high current yields right now that you could lock in for several years, which is also good for investors. It's a source of return.

5:37It's sort of an absurdly good set up. You just never really get stuff like this. And so like you said, Katie, even though companies in theory might want to borrow a few months down the line when interest rates have fallen, right now there is just so much investor demand out there for new corporate borrowing that they're saying, hey, why not? Might as well. Here's a good place to borrow. Yeah. And one of the kind of peculiarities around this is that so if you buy a corporate bond, then the yield, the rate of return that's available on it is kind of, it's got two main ingredients. One of them is what is the base rate, right?

6:11Where is the Fed rate now? So that's like five and a bit percent. And then you get an additional slug of yield on top of that to compensate the investor for taking on credit risk. So for betting on this particular company over this particular timeframe. And so that amount of extra depends on how safe or unsafe the company is as an investment bet. And those spreads, so the all-in yields are still pretty high because the Fed rate is still pretty high. It's at a 20-whatever-year high. But the spread, the additional slice that you get for the credit risk is like tiny, tiny, tiny in a way that says genuinely everything is awesome.

6:50And Ethan, you were writing about this in your newsletter either today or yesterday, I forget exactly which, but talk about some of those numbers because they are sort of bonkers. No, they absolutely are. And just to reiterate, a spread is the additional yield you get on top of a treasury. So it's that credit risk compensation component, what you're getting paid to take on the risk the company might go bust. And we've never really seen spreads quite this tight, but we have seen the general pattern in spreads before. And what tends to happen in history, and today in the Unhedged Newsletter, I took a look at a couple episodes of this happening in the past, is when investors kind of get the all clear signal from the economic data, then they're okay with spreads getting tighter.

7:34And this happened in the late 90s. This happened in the mid 2010s. This happened before the financial crisis. And all of these were periods where you had growth in the 2 % to 3 % to 4 % range and investors generally feeling good about where the economy and default risk was at. So they didn't need to get paid for the risk of companies defaulting. And some of these instances were bad. In 2007, if you bought corporate bonds, you didn't have a good time over the next couple of years. But if you didn't, if you bought them in 2016, it was a different story. It really depends on your recession call. But generally speaking, this kind of pattern of narrowing spreads just reflects investor confidence in where the economy is at.

8:15And with the latest GDP tracking estimates at three to 4%, it's kind of hard to blame people for trading that way. One thing that should arguably give us a little pause here is that even bankers that I speak to that sell corporate debt for a living are saying, this is kind of weird. And if you look through all of the 2024 year ahead outlooks from the banks and from a lot of the big investment firms, pretty much all of them have got long IG on it. I mean, I remember writing not so long ago, maybe like a year, year and a half ago, that look how tight these credit spreads are. This can't last. We're all worried about recession.

8:56Come on. And lo and behold, it did last. But I want to draw a comparison here, Katie, between the stock market, which we talked about before on Tuesday episodes with you. I mean, the stock market did hit all-time highs, as we discussed on a previous episode, but it didn't have this kind of ebullient bull market vibe. It was sort of like, I guess I'll rally to all-time highs if you want me to i don't really want to you called it in one of your columns katie the fun free party in stock markets and you had a covered photo of some very dour looking people yes um i said find a picture of some people at a party looking like they're having a horrible time yes and that's the it's it's totally different in in bonds it's very ebullient it's like very much the optimism the exuberance is there.

9:45I mean, why is that? Why are you getting in one market total unbridled optimism and in another market sort of half-hearted optimism slash ambivalence? Yeah, I don't know. It's the short answer to that question. But it is quite a weird situation in markets at the moment where you kind of look from one asset class to another. You look from equities to government bonds to credit to all over the place. And you can pick out very different signals from all of them at the moment, which I think tells you that levels of conviction in the round are really quite low and that people are still confused as hell about what is actually going on.

10:26We cannot get to a point where there's any consensus around whether recession has been averted or if there is a recession, how bad it's going to be. We can't kind of get our heads around is the stock market just telling you about the performance of one or two kind of massive monster stocks? Or is it telling us about something more broad? It's a very puzzling picture. Maybe one way to square the circle is I talked to a high yield investor recently who sort of made the point that the difference between equities and bonds is like equities are a story, a story about corporate earnings and what they're worth.

11:03Bonds are a contract. The company signs a deal with you, to pay you, unless it literally goes bankrupt, which doesn't happen all that often, really. Unless it literally goes bankrupt, it has to pay you. So there's an element of structural certainty built into a bond contract, which means that if the world is uncertain, bonds at least give you a little bit of certainty. Maybe you don't know what the economy is going to do, but you know that unless the company goes absolutely south in a catastrophic way, you're going to get paid at the end of the day. You can't say the same thing about equities.

11:33Yeah. And that, listeners, is why bond investors are a significantly more miserable bunch than equity investors, because they are constantly thinking about what can go wrong, what can take my money off me. Yeah, they don't have the unlimited upside and boundless optimism of the equity. No, definitely not. Well, that about sums it up. We'll be back in a minute with Long Short.

12:02Welcome back. This is Long Short, that part of the show where we go long, a thing we love, short, a thing we hate. Katie, I'm long the state of Delaware. Best known as the home of U.S. President Joe Biden. But recently, they've been in the news for getting crosswise of Elon musk he was just handed down a defeat in a shareholder compensation lawsuit uh or basically the delaware courts ruled like hey buddy this process was not kosher you can't put all your friends on the corporate board and tell them to pay you a lot of money it doesn't doesn't work like that uh and it's you know the same judge in delaware uh you know not too long ago handed elon a similar defeat on the uh twitter acquisition where they told him no you have to buy this company you sign the contract so i don't know i'm i'm long the i'm long the chance recorded of Delaware.

12:49It's known as an easy place to do business, but if you break the law, they will just enforce it in a very straightforward way. I respect that. They're tough. Don't mess with Texas, but don't mess with Delaware either. Yeah, really don't mess with Delaware. Well, given that you've been long, I'm going to have to be short, but I would also happily be long. but adam newman is back like oh yeah so the we work guy who was um you know politely often referred to as a charismatic entrepreneur so he wrote he wrote like we work into the ground the whole thing uh failed under his leadership um uh it was all a bit of a kind of disaster a bit of a a kind of perfect example of the mad excesses of the easy money era that someone so, quote-unquote, charismatic can lead such a massive company to like a$47 billion valuation or whatever and then crashes to the ground.

13:48Anyway, he's back. He wants to bring WeWork back from the ashes with the support of some hedge funds and he wants to be involved in this bid. Whether this will go anywhere or not, I don't know, But I just love these kind of lavishly funded, failing upwards, easy money guys who just keep coming back. They just never go. I love it. You know what? I'm sure, Katie, reportedly, this was a couple of years old, so I'm doing this from memory. But Adam Newman would walk barefoot around Soho in lower Manhattan because that was just his thing. That's his thing, man. I am short walking barefoot on the streets of New York City, just as much as I'm short.

14:29Adam Neumann's business career both seemed like perilous endeavors to me. I don't know. All right, Katie, thank you for being here. And listeners, we'll be back in your feed on Thursday with another episode of Unhedged. Catch you then.

14:44Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Porges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, and Natalie Sandler. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

15:27We'll be right back.