Reaching for (Negative) Yield
Yields on corporate bonds may be too low to cover losses from both defaults and inflation - perhaps making this the most dangerously overpriced corporate bond market of our lifetime.
U.S. Corporate bond yields have fallen in recent weeks and are once again approaching all-time lows. Investment grade bonds (which have an average credit rating of about A-/A3) only yield about 2.11%. High yield bonds (which have an average credit rating of about B+/B1) only yield about 3.89%.
In absolute terms these are historically low yields and should automatically be a cause for concern. But they are especially concerning in the context of reasonable estimates of future default losses and inflation, which in combination could very easily overwhelm these historically low yields - leaving most current buyers of corporate bonds with very real losses.
Based on historical experience (and a desire to keep the math simple), let us assume an average default rate of 3% and an average “loss given default” rate of 66%, i.e., let us assume a 2% average default loss rate (during a recession the default loss rate for corporate bonds is typically much higher). Since practically all corporate bonds that default are classified as high yield bonds at the time of default (the rating agencies are not completely incompetent!), an average investor in high yield bonds can expect to lose 2% of the current 3.89% expected yield from credit losses alone - leaving only 1.89% of potential positive return.
The problem is that we now live in a world where practically every estimate of the future rate of inflation - including the implied “breakeven” rate of inflation that is embedded in U.S. Treasury bonds of a similar duration - is over 2%. Therefore at current prices the average buyer of U.S. high yield bonds can expect to actually lose money in real terms. And even assuming that the default loss rate for investment grade bonds is 0% (which may be optimistic given the large cohort of BBB companies in that category - companies that may actually deserve to be rated as high yield companies) those estimates of inflation are also high enough to overwhelm the current 2.11% expected yield on such bonds. Therefore at current prices the average buyer of U.S. investment grade bonds can also expect to actually lose money in real terms.
Of course it could be supposed that somehow “this time is different” or that there has been some sort of fundamental change in the corporate credit market that justifies systemically lower yields. For example: perhaps the credit rating agencies have overcompensated for their epic failure during the period leading up to the 2008-2009 credit crisis and therefore these low yields now reflect their new overly-conservative credit ratings, e.g., a current B-rated bond is now really more akin to a BB-rated bond in terms of actual underlying credit quality (and thus should yield less than it did historically).
But the rating agencies seem to have learned nothing from their previous failures and instead appear to have spent the last decade reverting back to their old ways, using the “boom” phase of the current credit cycle to once again inflate their credit ratings and profit from the bias that is inherent in their business model. How else to explain why one of those agencies assigned an initial rating of BB- to the unsecured bonds of WeWork - a “business” that had recently burned billions of dollars, had no coherent business plan or a discernible path to profitability? (that same agency has since downgraded that bond four separate times to a current rating of CC - which probably should have been its rating from the beginning).
It seems highly unlikely that there has been some fundamental or systemic change that can somehow justify the current yields in the corporate credit market. Therefore - in the spirit of “Occam’s Razor” - the corporate credit market is probably exactly what it appears to be: one of the most dangerously overpriced credit markets of our lifetime. In such a market there is by definition no way to make money by simply indexing or buying a random basket of corporate bonds; on the contrary: the only possible way to make money in such a market is by being hyper-selective and successfully choosing which particular bonds to own. But most other investors will probably lose money.