Junk Bond Struggle

Investors are treating junk bonds like junk. The implosion of the housing market and the subprime mortgage troubles have spilled over into virtually every type of debt, including the junk-bond market—which is also known by its more genteel name, the high-yield market.

Made famous in the 1980s by Michael Milken, high-yield bonds are loans made to corporate borrowers that have less-than-perfect credit and then sold as securities to investors. Such bonds are either unrated by firms such as Standard & Poor’s or Moody’s, or they’re assigned ratings of BB or lower (on a scale that ranges from AAA for the highest-quality issues to D for bonds in default).

Investors trade high-yield bonds in the secondary market. Prices on these bonds fluctuate depending on interest rates and on the perceived risk that the debt may not be paid off.

Bond market professionals track the price of almost all bonds, including high-yield bonds, in relation to U.S. Treasury bonds of similar maturity. The difference in yield between them is called “the spread.” (Treasuries are the benchmark because they’re considered to be almost risk free.) When the difference between yields on junk bonds and Treasuries is small (also known as a narrow or tight spread), investors perceive relatively little risk in junk bonds. When the spread is wide, it’s another story, and that’s the story now.

Scott Schroepfer is the high-yield portfolio manager at RiverSource Investments, the asset management arm of the Minneapolis offices of Ameriprise Financial. He has the unenviable task these days of navigating a high-yield market littered with junk.

{Q} What’s driving the widening of the high-yield bond spread?

It’s worth looking back a year or so to get a sense of how dramatic the move has been. Starting in 2007, the spread in the high-yield market over Treasuries was about 320 basis points [or 3.20 percentage points]. That’s at the tighter end of the historical range. The spread actually got to all-time tight levels—265 basis points over Treasuries—in late May or early June of that year. Money was cheap, and access to money was very easy.

Then the issues with the subprime mortgage market hit and the high-yield spread started to widen out. We stabilized a bit last fall when people thought the subprime issues could be contained.