High Yield Debt: Credit Bubble And Litigation Risks

The past few years have seen a surge of high yield debt ("HYD") issuances. By some accounts, issuers sold more than $400 billion in HYD in 2012 and more than $500 billion in 2013, and the HYD markets are off to a healthy start in 2014.1 With yields on U.S. Treasuries, money market funds, and other investments depressed as a result of unprecedented monetary policy in the U.S. and EU, demand for HYD products continues to rise, fueled by yield-seeking investors.2 This increased demand has caused HYD bond prices to rise and yields to fall.3

As investment in HYD booms and the yield spreads over Treasuries shrink, some believe that the next credit bubble is growing and about to pop.4 If the bubble bursts, investor losses, governmental investigations, and litigation are sure to follow. This Commentary identifies potential litigation risks for those institutions engaged in the issuance and placement of HYD products and discusses several measures institutions can implement now to address exposure to those potential litigation risks.

High Yield Debt: The Basics

High yield bonds—sometimes referred to as "junk bonds"—are characterized by below-investment-grade credit ratings and therefore a greater risk of default than higher rated issuances.5 To compensate investors for this increased risk, issuers of HYD typically pay interest rates higher than those of more stable and higher rated investments such as money market funds or U.S. Treasuries. HYD was used widely in the 1980s by issuers seeking to fund hostile takeovers, enable large acquisitions, or invest in new businesses. Today, HYD issuers are often corporations attempting to improve their balance sheets by replacing expensive existing debt with new high yield bonds issued on more favorable terms. Despite the risk associated with high yield bonds, investors have increasingly turned to high yield debt offerings in an attempt to secure meaningful return in a slow-growth, low-interest-rate economy still recovering from the financial crisis of 2008.6

High Yield Debt and the Asian Markets

In addition to U.S. high yield issuances, the Asian markets, including emerging markets in Southeast Asia, have seen a surge in HYD offerings. In 2013, 60 percent of Asian debt market growth originated from the high yield sector, including a considerable rise in offerings in China (fueled by, among others, Chinese real estate developers), India, and Southeast Asia. Issuers in Indonesia and the Philippines also tapped the market beginning in the middle of last year.7 Indian HYD issuers made record offerings in 2013, including, for example, a $1.2 billion offering by an Indian natural resources and mining company, for which U.S. investors purchased more than 50 percent of bonds.8 Major U.S. investors reported seeing value in Asian HYD offerings in 2013 despite record high bond prices.9

Investor appetite for Asian HYD did not taper off in 2013, despite increased offerings from the more challenging emerging markets such as Indonesia and the Philippines, and despite offerings with complex structures that could contain higher risks.10 Analysts have been warning for months that the growing high yield bubble could extend to the Asian market, citing increasingly lower-rated issuances and growing capital inflows, but such fears have not yet materialized.11

High Yield Debt and the Return of Structured Products

The reemergence of complex structured products designed to leverage exposure to high yield debt, such as collateralized debt obligations ("CDOs") and collateralized loan obligations ("CLOs"), suggests that investors have exhausted the favorable returns traditionally available through so-called "plain vanilla" high yield debt instruments and are now turning to more highly leveraged complex products to search for yield.12 In 2012, global CDO sales surged fourfold to approximately $55 billion, and jumped up again to $87 billion in 2013, with 26 percent of those global sales occurring in the fourth quarter.13 Approximately $23 billion of the $87 billion in CDO issuances in 2013 were backed by high yield loans.14

The Possibility of a High Yield Debt Bubble?

The increased flow of cash into the HYD market has begun to drive down the spread between interest rates and high yield issuances, causing some to speculate that a credit bubble may be forming in U.S., global, and emerging markets.15 As early as February 2013, analysts and media commentators warned of investment red flags indicating a growing HYD bubble. These red flags include: (i) increasing bond prices paired with lowering yield; (ii) increased merger and acquisition activity; (iii) the high proportion (more than 15 percent) of distressed credits that comprised the U.S. high yield market; and (iv) the increasing use of structured products such as CLOs in the high yield debt market.16...