Here's how junk bonds became a 'quiet haven' for investors, says BAML

High-yield corporate paper is up 1.8% for the year, while emerging market debt is down 5%.

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Are junk bonds a "new safe haven" for investors?

That question comes from Oleg Melentyev, an analyst at Bank of America Merrill Lynch, who wrote a note last week in an effort to explain the resilience of high-yield corporate debt, or junk bonds, in a turbulent year for financial markets.

Granted, it might sound odd to refer to junk bonds as a haven given their association with excessive leverage and an increased danger of default, not the port-in-a-storm attributes embodied by U.S. Treasurys or the Japanese yen.

But Melentyev isn't saying investors have scurried into high-yield, corporate bonds, which sport a below investment-grade credit rating, to shelter from market volatility. Rather, he's explaining why the asset class has managed to outperform other portions of the credit market.

"The high yield market has taken on a new role this year, which is being a relatively quiet haven in an environment where many other key asset classes...have experienced at least temporary, if not more substantial repricing," wrote Melentyev, head of high-yield credit strategy at BAML, in a note published Friday.

U.S. high-yield debt is up 1.8% this year. Its performance may pale to the go-go returns of the S&P 500 (.SPX), but junk bonds have managed to evade the turmoil that has ravaged emerging markets and even investment-grade paper, its more creditworthy peer. High-grade corporate bonds are down 2.4%, and dollar-denominated emerging market sovereign debt lost 5%, according to data from CreditSights.

The extra yield demanded by investors for buying high yield debt over safer Treasurys stands at 3.48%, four basis points below where it started at the beginning of the year, according to the benchmark ICE BAML bond indexes. A narrower yield premium can reflect investors have an increased appetite for junk debt.

Melentyev says the outperformance stems from three reasons: tax cuts, diminished supply and a gentle pace of monetary tightening.

Tax cuts signed into law by President Donald Trump have lifted corporate earnings, improving the ability of highly leveraged firms to handle the hefty debt loads on their balance sheets. The most indebted quartile of high-yield issuers have seen a sharp decline of the ratio between their debt and pretax earnings to 7.8 times in June from 8.4 times in last December.

Coupled with a favorable supply and demand setup, high-yield bond prices have enjoyed a gentle tailwind, too. Total issuance of high-yield corporate paper is down 22% year-to-date compared with the same period last year, according to data from BAML.

Finally, the Fed's decision to gradually tighten monetary policy has, in effect, deferred the impact of rate increases and higher borrowing costs on junk bond issuers, said the BAML strategist. Against a backdrop of solid economic data, Federal Reserve Chairman Jerome Powell signaled that policy makers are on track to deliver two more rate increases this year and three more in 2019. That outlook will also encourage corporate managers to continue cutting down debt loads, a boon for high-yield investors.

"The longer this deleveraging process lasts the higher the likelihood of an extended credit cycle, and the more room the Fed has to eventually normalize policy," said Melentyev.

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