Prices of risky US companies’ debt have risen sharply this year as investors bet the Federal Reserve will bring inflation under control without triggering a damaging recession.
Yields on US junk bonds — debt sold by businesses with low credit ratings — have fallen by more than one percentage point since the end of 2022, according to an Ice Data Services index, trading at an average of 7.97 per cent. The decline reflects a sharp increase in prices.
In turn, the gap between junk yields and those of US government bonds has narrowed by more than 0.8 percentage points to less than 4 percentage points — the first time it has sat below that level since last April.
The shrinking “spread” implies waning expectations of debt defaults for the $1.8tn low-grade corporate bond market. It also reflects continued bets that the Fed will be able to relax its aggressive tightening of monetary policy sooner than the central bank has indicated — reducing the likelihood of a sharp economic downturn.
“I think the market’s absolutely priced for a soft landing,” said John McClain, portfolio manager at Brandywine Global Investment Management. “It’s been a combination of January euphoria, which has led to higher equity prices, and higher equity prices have pulled along high-yield credit spreads.”
Evidence of cooling US inflation has helped to fuel the upbeat mood, with December’s consumer price index reading dropping for the sixth month in a row, down to 6.5 per cent from a peak of 9.1 per cent in June.
In turn, futures markets are pricing in expectations that US government borrowing costs will rise to a peak of 5.1 per cent in July, before falling to 4.8 per cent by the end of the year.
Those bets come even as Fed officials themselves have indicated they expect rates will remain above 5 per cent in December, and after the latest jobs report signalled a hotter-than-predicted labour market.
US employers added 517,000 new roles in January, compared with forecasts of 185,000, despite the central bank’s efforts to pour cold water on an overheating economy.
“The macro picture has definitely improved, with inflation easing sequentially,” said Kelly Burton, high yield portfolio manager at Barings. “The jobs data alone [suggests] we’re not heading to a deep recession in the near-term.”
Burton also highlighted technical factors driving this year’s junk bond rally, with spreads and issuance improving from a weak base.
“We were coming off a year with hardly any issuance since companies were able to patiently wait out the volatility,” she said. “I think it’s more of that starting point that has generated interest in [high-yield] as well as the technical backdrop”.
Dominique Toublan, US head of credit strategy at Barclays, said 2023 had begun with people having “money to invest” because they had “been defensive for quite a long time” and there was “a little bit of [fear of missing out] going on”.
At the same time, he said, “people who had been short” — betting against improvements in credit prices — “decided not to be short anymore, so they removed hedges”.
High-yield spreads might continue to tighten in the short-term, said Toublan. But he anticipated them widening later this year, “quite significantly from where we are”.
Marty Fridson, chief investment officer at Livian Lehmann Fridson Investors, also predicted the gulf in yields between junk bonds and low-risk Treasuries to broaden. “You still have a lot of signs pointing to recession,” he said.
Spreads could increase by as much as two percentage points, Fridson added, “as that expectation starts to change from ‘everything’s fine, the Fed’s going to pivot, we’re going to have a soft landing’.”
“Historically, the high-yield market has not really anticipated recessions very well,” he said. It is “not unprecedented” for the market to be “ignoring the flashing yellow lights”.
For Brandywine’s McClain, the “conflicting data” of recent weeks “provides cover for the Fed to continue along its path of additional rate hikes followed by what we believe is a long pause”.
He predicted a scenario where the US avoids recession was “becoming more and more likely”. However, he said there was a high chance that the US economy would see a pick-up in inflation later this year which could create fresh challenges for the central bank.
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