(Bloomberg) — Investors chasing fat yields in US corporate debt aren’t being properly compensated for the risks, warns junk bond guru Marty Fridson.
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“Investors systematically overpay for industries that offer higher-than-median yields,” Fridson, whose debt analysis has been studied by Wall Street for decades, wrote in a report Wednesday. Bond buyers, he added, are “earning inferior risk-adjusted returns.”
Fridson’s analysis points to a growing danger bubbling beneath the surface of the high-yield debt market, where a bullish consensus is underpinned by expectations for robust growth in the US economy. Junk spreads dropped this month to the tightest since the start of 2022 as investors raced to lock in historically large yields on the debt before more US central bank easing starts to erode returns.
Surging demand and a lack of supply is encouraging riskier borrowers to come to market — including with loans for dividends and deals that can be repaid with new debt — raising fears that credit risk is not being priced appropriately.
Competition for investment dollars is forcing mutual funds to chase higher yields, Fridson said. But they often don’t fully account for illiquidity and default risks, according to the chief executive officer of FridsonVision High Yield Strategy.
In a perfectly efficient market, credit gains should vary according to the level of potential downside. But Fridson’s review of corporate bonds by sector going back almost 30 years shows that industries with elevated yields also have lower risk-adjusted returns, as measured by Sharpe ratios.
If buyers were rational, differences in risk-adjusted returns should divert capital to superior borrowers, erasing gaps. However, debt in the telecommunications sector offers more yield — but with a lot more volatility and risk — than aerospace bonds over the long haul, and other industries show similar differentials, according to Fridson.
“Empirical analysis fingers yield chasing as the culprit,” Fridson wrote. From 1997 to 2003 aerospace offered a mean return 61% higher and a standard deviation 44% lower than telecommunications, he added. “An investor blessed with perfect foresight would have seen aerospace as a much better industry for overweighting.”