Gross on junk: Curb your enthusiasm

High-yield market isn't overheated yet, but it's getting close, he contends

Pacific Investment Management Co. LLC’s Bill Gross isn’t ready to say that the high-yield-bond market is overheated, only that it is getting there.

In his newest investment outlook, he estimates that the high-yield market is at about a 6 on a scale of 1 to 10 measuring asset price irrationality and is moving higher.

“Corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced. Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile,” Mr. Gross wrote.

It isn’t the current prices — which have compressed the spread between high yield and Treasuries — that concern him. Instead, it is the record issuance.

Mr. Gross points to research by Harvard University’s Robin Greenwood and Samuel Hanson showing that the new issuance of bonds is a better measure of future growth than spreads.

“When the high-yield share [of issuance] is elevated, future returns on corporate credit tend to be low,” the research paper concluded.

Last year, investors bought more than $100 billion worth of high-yield bonds and leveraged loans, higher than the previous peaks in 2007 and 2006.

Still, Mr. Gross isn’t advising that investors ditch their junk bonds altogether, but he does caution them to curb their enthusiasm.

“Recent double-digit returns are unlikely to be replicated, and when today’s 5% to 6% high-yield interest rates are adjusted for future defaults and recovery values, 3% to 4% realized returns are the likely outcome” he wrote.