Inflation ‘Erases’ High Yield Name From Junk Bonds

Runaway inflation in Europe is causing new implausible situations in fixed income. If zero rates pushed sovereign debt to negative interest; now with the strong rebound in prices and with the ECB maintaining extraordinary measures , junk bonds also known as High Yield offer a negative return with interest adjusted for inflation.

In financial jargon, High Yield bonds are those that offer a high yield upon maturity. They are also known as junk bonds as they are issues with a credit rating that carry investment risk due to the high probability of default by the issuer.

The problem is that this name in English has lost its meaning when inflation in the euro zone has shot up to 3% . For the first time, the adjusted yield of junk bonds offers negative interest to investors . The name almost remains an anecdote, when the implications that it entails in the market are analyzed.

For many experts it represents a new phase of the corporate income bubble. Demand for High Yield has exploded in recent years despite the fact that profitability was being curtailed. Investors have opened up to these assets in parallel with sovereign bonds sinking into negative territory . The zero rate policy by the ECB has laminated interest on all types of assets and junk bonds have not been an exception.

The problem has come with the upturn in inflation that supposes net losses for investors who hold these bonds until maturity. The pandemic and already the strong demand created has caused record emissions by companies , but the entry to negative rates opens the door to a barrage of bond sales.

Many investors buy and sell in the short term, benefiting from escalating prices

Negative interest appeared last month in a dozen companies with junk-rated euro-denominated debt. But the market, far from being scared, is floating in liquidity. Many investors buy and sell short-term, benefiting from escalating prices. Bonds are priced the same as stocks, they move hands with swings in price.

But corporate debt has the peculiarity that it has a coupon, which usually acts as a premium at maturity. That is, the investor who has a bond receives the principal plus the initial interest. In the secondary market, as the price of debt rises and falls, interest moves in the opposite direction. If the price rises too much, the interest goes negative, as is currently the case.

“Most market participants think it will return to previous levels once the ECB’s Covid stimulus is withdrawn,” Konstantin Leidman, manager of Wellington Management International, which manages more than $ 1 billion, tells Bloomberg. in European high yield assets.

The manager warns that “if not, it will be a problem for the market.” Investors keep buying bonds because of the price hikes, but none will want the losses to maturity.

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