Risky Corporate Bonds in 2021: A Bubble, or Rational Underwriting in a Low-Rate Environment?

In response to the pandemic, the Federal Reserve and US Treasury aggressively supported the corporate debt markets in 2020, both through easy monetary policy and direct participation. As the economy recovered, the Fed maintained an easy monetary policy in pursuit of more robust employment, gross domestic product growth, and inflation targets. Many observers have asserted that these policy actions and other factors have driven a bubble in risk assets, such as equities, special purpose acquisition companies, real estate, commodities, cryptocurrencies, nonfungible tokens, and risky bonds. Others believe that the valuations for at least some of these assets reflect investors’ rational incorporation of the current interest rate environment and economic outlook into their underwriting assumptions. Here, the authors analyze this question with regard to one of the riskiest classes of debt securities — the CCC-rated portion of the corporate high-yield debt market — to draw broader conclusions about the leveraged credit markets in the United States. Using historical market metrics, this portion of the market at its recent peak offered almost no excess return to compensate investors for the risk taken relative to low-risk alternatives. From this, the authors conclude that investors are underwriting significantly more optimistic outcomes than those reflected in historical averages. Although the authors believe that this segment of the market falls short of a true bubble, as they define it, they warn that current conditions pose key risks to investors and to the broader economy.