(Bloomberg) — Investors seeking high returns in U.S. corporate debt are not being properly compensated for the risks, junk bond guru Marty Fridson warns.

“Investors systematically overpay for sectors that offer above-median returns,” Fridson, whose debt analysis has been studied by Wall Street for decades, wrote in a report Wednesday. Bond buyers, he added, “earn lower risk-adjusted returns.”

Fridson’s analysis highlights a growing danger bubbling beneath the surface of the high-yield debt market, where a bullish consensus is supported by expectations of robust growth in the U.S. economy. Junk spreads fell this month to their tightest level since early 2022, as investors rushed to lock in historically high yields on debt before further easing by the US central bank begins. to erode yields.

Rising demand and a lack of supply are encouraging riskier borrowers to come into the market – including loans for dividends and deals that can be repaid with new debt – raising concerns that credit risk will is not properly assessed.

Competition for investments forces mutual funds to seek higher returns, Fridson said. But they often don’t fully consider illiquidity and default risks, according to the CEO of FridsonVision High Yield Strategy.

In a perfectly efficient market, credit gains should vary depending on the level of potential decline. But Fridson’s examination of corporate bonds by sector over a period of nearly 30 years shows that sectors with high yields also have lower risk-adjusted returns, as measured by Sharpe ratios.

If buyers were rational, differences in risk-adjusted returns should divert capital to better-performing borrowers, thereby closing the gaps. However, telecom sector debt offers more yield – but with much more volatility and risk – than aerospace bonds over the long term, and other sectors show similar spreads, according to Fridson.

“Empirical analyzes indicate that the prosecution is the culprit,” Fridson wrote. From 1997 to 2003, aerospace delivered an average return 61% higher and a standard deviation 44% lower than telecommunications, he added. “An investor with perfect foresight would have viewed aerospace as a much better sector to be overweight.”

The high-yield bond market became even more expensive last month, according to Fridson. Junk spreads are expected to be 486 basis points – up from 288 basis points at Tuesday’s close – to account for current credit availability, economic indicators, default rates, Treasury yields and easing quantitative, shows Fridson’s analysis.

“High yield is decidedly rich right now,” he writes.

©2024 Bloomberg LP