The US junk bond market has a strong rally to ease inflation concerns

The US junk bond market has a strong rally to ease inflation concerns

One of the riskiest corners of global financial markets has made an unprecedented recovery over the past month, with junk bond prices rallying as investors bet that the Federal Reserve’s efforts to control inflation will avoid triggering a deep recession

The amount of U.S. Treasuries trading at levels that indicate serious investor concern has fallen sharply over the past five weeks, reflecting increased investor optimism about the state of the North- American

Just 6.2 percent of high-yield bonds are now trading at distressed levels, compared with 11.6 percent on July 5, according to analysis by Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors.

Investors had pulled back from high-yield US corporate debt earlier this year, fearing that the Fed’s aggressive rate hikes would force the world’s largest economy into a prolonged slowdown, affecting more strongly the weakest companies in the country.

But signs that the pace of price growth may be steady, with inflation data last week below expectations, have contributed to a recovery in the price of these assets.

“In a surprisingly short interval, high-yield investors [have come] around believing that inflation is sufficiently under control that the Fed [will] there is no need to raise interest rates dramatically enough to trigger a deep recession,” Fridson said. “Time will tell if they were right to change their views on this issue.”

The lack of demand before the rebound in junk bond prices had pushed up the premium investors received for holding high-yield bonds relative to government benchmarks, also known as the spread. The amount of bonds traded with a spread of 10 percentage points or higher, a sign that they are in difficulty, more than doubled from January to May.

“Credit, like stocks, is a simple animal,” said Michael Hartnett, chief investment strategist at Bank of America Global Research. “As interest rates rose and corporate profits fell, the first six months of this year were an environment where spreads widened dramatically.”

The difficult conditions prompted some companies to postpone planned loans as central banks withdrew their support for debt markets and inflation dampened demand.

But several data releases have suggested that inflation has stabilized in the US economy, meaning expectations that the Fed will deliver a third consecutive 0.75 percentage point rate hike in September have been have reduced

A renewed sense of optimism about the economic outlook has returned traders to debt markets. Money has poured into emerging market, high-yield and investment-grade debt funds in recent weeks, following sustained outflows since January, according to flows tracked by EPFR.

Weekly flows to debt funds

With banks delaying planned junk bond sales until after the US summer holidays, investors interested in increasing their holdings have had to gobble up existing debt. U.S. corporate bond yields with junk ratings have fallen from an average of 8.94% at the end of June to 7.45% on Friday.

That decline has been largely driven by a drop in the premium investors are borrowing from lower-rated companies compared to the costs of borrowing backed by the US government, rather than a broader drop in yields. The spread narrowed from 5.99 percentage points on July 5 to 4.25 percentage points on Friday.

What’s most surprising is the pace of this “extraordinary” turnaround, Fridson said. It previously took at least four months for the spread in Ice Data Services’ high-yield index to go from 6 percentage points to its current level of 4. The recent decline has taken just over a month, the data show by Fridson.

“Without the sense of inevitability of a near-term recession, investors are predisposed to take a bullish view on any good news,” he said, although some traders remain reluctant.

Gabriele Foà, portfolio manager at Algebris Investments, said conditions in the corporate bond market are likely to improve further. “This is the tip of the iceberg of what credit can do . . . the levels were crazy and priced for a very large storm. Now they’re not priced for a very large storm, but they’re still pretty cheap “.

But Adam Abbas, co-head of fixed income at Harris Associates, warned that when debt issuance accelerates later this year, pressure could once again mount on junk bonds just as investors s ‘face the weakness of economic data.

“There has to be some degree of skepticism built into the credit analysis,” he said. “A conciliatory pivot of [Fed chair Jay] Powell, a good employment report and [softer than expected rise in consumer prices], sure they are good. But the verdict is still out for us.”

More inflation and jobs data will be released ahead of the Fed’s rate decision next month. Signs that inflation is picking up again or a bigger-than-expected rise in interest rates could push bonds higher into distressed territory.

The long-term outlook means analysts are wary of predicting a new bull market for credit. “If you think corporate earnings are going up and interest rates are going to come down, winner, winner, chicken dinner. If, like me, you don’t think it’s going to be that easy, the expected returns don’t look that attractive,” he said. said Hartnett.


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About the Author: Chaz Cutler

My name is Chasity. I love to follow the stock market and financial news!