There's a bubble brewing in high-yield U.S. bonds: UBS

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The market is failing to recognize a bubble in lower-quality U.S. bonds, which could begin to default at an unprecedented pace if the economy falters, according to a new report from UBS.

High-yield bonds have rallied lately, such that investors are not anticipating substantial credit stress, nor are they compensated adequately for the level of risk involved, UBS credit strategists Matthew Mish and Stephen Caprio wrote.

"We believe there is a corporate credit bubble in speculative grade credit," the report said. "While this bubble and possible mini-bubbles may not pop this month, we believe their existence justifies our structurally bearish view on corporate credit and preference for higher-quality securities."

The post-crisis era has seen a booming trade in lower-quality issuance as investors stretching for yield have sought to compensate for the low-rate environment.

"This translated into competition for bond issuance, easing credit standards, massive supply at record low yields and an underestimation of risks," the report's authors said. Central bank stimulus kept many companies that might have otherwise failed afloat.

The U.S. speculative grade market is now comprised of about $1.5-trillion in bonds and another $1-trillion in loans. UBS estimates that $1-trillion of that will become distressed this credit cycle.

While the current trailing default rate is now just 4 per cent, the commodity downturn will push that up to 5 to 6 per cent without factoring in any change in non-resource defaults. The default rate could go much higher in the event of a broader economic slowdown, to which indebted, lower-quality companies are vulnerable, the report said.

Meanwhile, historically low yields on treasuries and investment grade credits fueled investor interest in higher-yield income funds, UBS said. "Investors were herded into lower-quality credit risk for a yield pick-up of a couple hundred basis points."