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

Abstract

In Risky Corporate Bonds in 2021: A Bubble, or Rational Underwriting in a Low-Rate Environment?, which appeared in the November 2021 issue of The Journal of Portfolio Management, authors Edward Altman (Stern School of Business, New York University, and NYU Salomon Center for the Study of Financial Institutions) and Mike Harmon (Gaviota Advisors, LLC) attempt to determine whether current market factors have driven a “bubble” in the US high-yield bond market.

In order to determine whether the current market conditions in high yield truly represent those of a “bubble,” the authors analyze the highest-risk segment of this market. Based on historical average default and recovery rates, they conclude that the expected returns from the securities analyzed are not commensurate with the high risk associated with those securities. Furthermore, the authors’ analysis of key factors influencing future default and recovery rates yields the conclusion that there are more potential scenarios for investors to underperform than there are for investors to outperform. Although the conditions analyzed do not represent a true “bubble” as defined by the authors, they do express concern over other potential negative repercussions resulting from investors’ assumption of excessive risk.