Corporate bonds

Double whammy for low-rated corporate bonds

At the end of a hectic week for low-rated corporate bonds, it is the Federal Reserve, not the Omicron coronavirus variant, that remains the biggest concern for investors in the asset class.

By now, many debt investors have grown accustomed to the sharp swings in the markets after a surge in Covid-19 cases sparked a sell-off. The spread of the new Omicron variant is the latest iteration, and the weary response from glassy-eyed portfolio managers points to the thoughtful expectation that debt prices will recover from the latest jolt. They have after every previous Covid setback, after all.

“We see it as a buying opportunity,” echoed several bond managers in conversations this week. In other words, the “Buy the Drop” mantra still holds true for many.

Unlike previous shocks, however, this one came just as the crisis support measures for the markets began to be withdrawn.

Fed Chairman Jay Powell said in testimony to Congress this week that it might even be appropriate to speed up the dismantling of these measures in a bid to tackle high inflation, abandoning its use. from the word “transient” to describe the upward pressure on prices.

This constitutes a form of monetary tightening – not what one would expect if Omicron were to derail the recovery. If Omicron ends up dampening the current US economic recovery, low-rated bond investors could face a double whammy.

Tighter monetary policy drives up interest rates, raising the cost of borrowing for businesses and lowering the prices of existing bonds as they become less attractive.

This usually affects higher rated debts earlier than lower quality bonds despite the issuer’s greater repayment capacity. For higher quality debt securities, base interest rates represent a larger portion of the overall return.

The performance of a widely watched index of better and higher quality corporate bonds managed by Ice Data Services has been steadily rising since August, amid expectations that the Fed would begin to end its program. bond purchase of $ 120 billion per month. , undermining the liquidity of financial markets.

High yield bonds are generally more resilient to changes in Fed policy. The returns on this debt are based more on an assessment of the higher risk of lending to lower quality issuers. Thus, a lower proportion of the overall return on high yield debt represents base interest rates. And rising interest rates are offset by improving corporate fundamentals, reducing the risk of lending to lower-rated companies.

Still, even before Omicron disrupted junk debt just over a week ago, yields had started to rise in response to the Fed’s expected reduction in bond buying.

The emergence of cracks in the debt of lower-rated companies is puzzling, especially given the deluge of low-rated triple-C borrowers that have entered the market this year and the continued weakening of lending standards and debt. investor protection in agreement documents.

The recent massive selloff means the return on a triple-C-rated debt index nearly ended a round-trip for the year in November, after peaking in January of 8.33 percent, falling to a low in January. July by 6.28 percent. percent, before rising nearly a percentage point last month to 8.28 percent.

Investors are by no means rushing to their panic posts. The performance of the overall Ice High Yield Bond Index is still close to levels reached last year when euphoria over the first successful Covid vaccine trials dominated the narrative.

Default rates remain low and are expected to remain so next year. And for investors looking for higher yields with interest rates kept low around the world, the US junk bond market remains attractive.

Yet a more cautious tone is setting in, visible elsewhere on Wall Street as well. The spread between short-term and long-term Treasury yields fell to its lowest since January, signaling slowing expectations for economic growth.

The Russell 2000 index of more domestically focused small businesses – considered a barometer of the overall health of the U.S. economy – fell more than 10% this week from its recent high before rebounding Thursday.

The Atlanta Fed is still forecasting exceptional growth of around 10% in the United States for the fourth quarter, but markets are still trying to take a closer look at where the economy is going, not where it is now.

Some investors are warning that the Fed could find itself tightening monetary policy to fight inflation just as the economy begins to calm down. And this is where Omicron’s risk – even if it’s not the main risk of concern to investors – comes into play. Powell may have to choose between tackling inflation or slowing growth. He may not be able to do both.

In such a tug-of-war environment, the monetary policy error, as one bond fund manager put it, is the biggest potential risk heading into 2022.

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Robert Armstrong dissects the most important market trends and explains how the best minds on Wall Street are reacting to them. Register here to receive the newsletter directly in your inbox every day of the week