US junk bond market rebounds strongly as inflation concerns ease

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One of the riskiest corners of global financial markets has seen an unprecedented rally over the past month, with junk bond prices rebounding as investors bet the Federal Reserve’s efforts to tame inflation will stave off trigger a deep recession.

The amount of US bonds trading at levels signaling serious investor concern has fallen rapidly over the past five weeks, reflecting heightened investor optimism about the state of the US economy.

According to analysis by Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors, only 6.2% of high yield bonds are now trading at distressed levels, down from 11.6% on July 5.

Investors had dumped high-yield U.S. corporate debt earlier this year, fearing that aggressive interest rate hikes by the Fed could force the world’s largest economy into a prolonged slowdown, hitting the hardest companies the hardest. weak in the country.

But signs that the pace of price growth may be stabilizing — with inflation data last week coming in lower than expected — have contributed to a rally in the price of these assets.

“Over a surprisingly short span, high yield investors [have come] around believing that inflation is sufficiently under control that the Fed [will] not having to raise interest rates big enough to trigger a deep recession,” Fridson said. “Time will tell if they were right to change their minds on this issue.”

A lack of demand ahead of 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 trading with a spread of 10 percentage points or more, a sign that they are in trouble, 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 earnings declined, the first six months of this year was an environment where spreads widened significantly.”

Tough conditions prompted some companies to postpone planned borrowing as central banks withdrew support from debt markets and inflation dampened demand.

But several data releases suggest inflation has stabilized in the U.S. economy, meaning expectations that the Fed will make a third consecutive 0.75 percentage point hike in September have eased.

Renewed optimism about the economic outlook sent traders back to debt markets. The money has flowed into investment grade, high yield and emerging market debt funds in recent weeks, following sustained outflows since January, according to flows tracked by EPFR.

Weekly flows to debt funds

As banks delay planned junk bond sales until after the U.S. summer vacation, investors eager to boost their holdings have instead had to gobble up existing debt. Yields on junk-rated U.S. corporate bonds fell from an average of 8.94% in late June to 7.45% on Friday.

The drop was largely due to a fall in premium demand from investors to lend to lower-rated companies relative to US government-backed borrowing costs, 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.

Most striking is the pace of this “extraordinary” turnaround, Fridson said. It has already taken at least four months for the spread on the high-yield index Ice Data Services to fall from 6 percentage points to the current level of 4. The recent decline took just over a month, according to the Fridson data.

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

Gabriele Foà, portfolio manager at Algebris Investments, said corporate bond market conditions should improve further. “That’s the tip of the iceberg of what credit can do. . . the levels were insane and the price a really big storm. Now they’re not priced for a really big storm, but they’re still pretty cheap. »

But Adam Abbas, co-head of fixed income at Harris Associates, warned that when debt issuance picks up pace later this year, pressure could again be on junk bonds just as investors face declining economic data.

“There has to be a degree of skepticism in credit analysis,” he said. “A dovish kingpin of [Fed chair Jay] Powell, a good jobs report and [softer than expected rise in consumer prices], these are certainly good. But the verdict is still in for us.

More inflation and employment data will be released ahead of the Fed’s rate decision next month. Signs of rising inflation or a larger-than-expected rise in interest rates could push more bonds into troubled territory.

The longer-term outlook means analysts are hesitant to predict a new bull market for credit. “If you think corporate profits are going up and interest rates will go down – win, win chicken dinner. If, like me, you think it won’t be so easy, the expected returns don’t look so appealing said Hartnett.

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