Junk Bonds at the Forefront of the Next Big Financial Crisis

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When interest rates are low, the chance for large returns on many investments is also low. As a result, high-yield debt issuances or junk bonds, have grown in popularity due to consistently low interest rates. The benefit of junk bonds is that they offer one of the only games in town for investors looking to hit it big.

Unfortunately, the popularity of highyield debt has combined with falling underwriting standards and rising interest rates to create a recipe for financial disaster. This trifecta, if you will, has laid the groundwork for the next credit bubble. When these bubbles burst, they leave investors scrambling for cover as governmental investigations and litigation commence.

A Portrait of High-Yield Debt

A bond is junk if the likelihood of the issuer making the interest payments or repaying the principal at the time of maturity is poor. Because the risk of default is high, junk bond issuers must offer more incentives to attract investors.

The SEC does not regulate high-yield bonds. Junk bonds are loans, and are therefore not subject to the same rules regarding disclosure and participation that other investment products must follow. Companies that issue junk bonds (borrowers) and underwriters can limit access to their financials. They can control what data purchasers receive. They can even refuse to sell their debt to specific investors. Some may do this to avoid litigation or to avoid investors who might agitate for superior creditor rights.

Junk bonds hit a relative low point in 2008. The trend reversed with highyield debt issuances hitting a record high in 2014. Many of these bonds will start coming due next year, with more in successive years.

As is often the case, the next financial crisis took root in the bones of the last. The implosion of collateralized debt obligations (CDO) drove the most recent crash. CDOs are the type of financial product banks keep on their books. They include mortgages, investmentrated bonds and other cash flow-generating assets.

The failure of this market drove many investors to pursue collateralized loan obligations (CLO) which had not suffered the same difficulties. Unfortunately, CLOs force investors to assume most of the risk in the event of a default. The market for CLOs is illiquid. That means if the debt-issuer falters, investors have no easy way to get rid of them without suffering significant losses. If the investor is a fund that is required to dispose of losing investments or a regional bank in need of cash, CLOs can spell disaster.

Falling Standards in Underwriting

In good times, investors demand certain protections before putting their money on the line. Before loaning money, they establish collateral, favorable payment terms, and gather information about the ability of the debt issuer to pay. So-called covenant-lite loans involve an easing of those restrictions.

As the demand for high-yield debt has grown, the standards for who could plausibly issue junk bonds and still attract investors have fallen. Borrowers who are high-risk are able to obtain loans without disclosing vital information. Companies with massive debt and minimal equity (highly-leveraged firms) have taken advantage of these weaker loan structures to create massive credit risk. Large banks, particularly those with investment banking operations, have eased their standards more than ever.

Interest Rates

Low interest rates have driven much of the interest in junk bonds. Investors are desperate for opportunities to find a significant yield. The prolonged low interest rate environment means investors will continue to be vulnerable to the temptation of high-yield bonds. This is true across a wide spectrum of investors, including large-asset managers.

The question arises, what happens when interest rates tick upward? When the rates rise, high-yield debt products will suffer most from the stress. Repayment obligations will force many of the riskiest borrowers to default.

The Result of the Trifecta

The impact of the trifecta – the increasing popularity of junk bonds, the falling underwriting standards and the impending rise in interest rates – will be widespread. Investors in CLOs and whole loan portfolios will lose. CLO managers will not be able to satisfy the demands of debt issuers/underwriters and the investors who want recovery for their losses. The underwriters will likely have a lot of explaining to do when investors look for someone to blame.

Participants in the high-yield market will likely ride a wave of litigation. Investors will bring claims designed to recoup some percentage of their losses. These claims could include allegations that issuers and underwriters had superior knowledge of the risks and failed to share that knowledge with investors.

Investors will parse the documents governing specific transactions to find where sell-side parties breached their obligations. CLO managers have a fiduciary duty to their clients. Investors will likely allege that they failed in that duty when it comes to proper valuation of the investments and information provided about the declining value of the assets in the funds they manage.

There will, once again, be questions about the unregulated nature of the junk bond market. Regulators, politicians and financial experts will discuss the inefficiencies of the market and the opaque nature of many of these transactions at length. The ultimate question left to ponder is when, not if, the trifecta will come to a head to create the financial cataclysm that lies before us.

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