Corporate bonds

Some investors doubt the summer surge in U.S. corporate bonds will last

A meteoric rebound in U.S. corporate bonds is being met with skepticism by some investors, who believe the gains may be short-lived as recession fears cloud the outlook for the $10 trillion market.

Hopes that the Federal Reserve will be less aggressive than expected in its fight against inflation have contributed to a powerful rebound in the markets in recent weeks, fueling big gains in many assets that had suffered during a first-half sell-off. semester 2022.

Corporate bonds were no exception. Total returns for dollar-denominated junk bonds, as measured by the ICE BofA US High Yield Index for July, were the highest since 2009, while those for investment-grade debt were the highest since November 2020 .

Some investors believe the recovery could falter if it becomes clearer that the Fed’s series of giant rate hikes is slowing economic growth. Others worry that the Fed’s reduction in its balance sheet, known as quantitative tightening, could present another hurdle for credit in the coming weeks.

“I don’t think we’re out of the woods, but we’re not as deep into it as we were a few months ago,” said Eric Theoret, global macro strategist at Manulife Investment Management.

Theoret thinks credit is likely to weaken again as evidence of a slowing economy mounts, but not beyond the lows it saw earlier in the year.

Some Fed officials in recent days have pushed back on the notion that the central bank was on the cusp of an accommodative pivot, a narrative that helped accelerate asset price gains after its monetary policy meeting last week. .

More evidence of whether the 225 basis points of economic tightening the Fed has already delivered is slowing growth is on the way as investors await Friday’s U.S. jobs data and inflation numbers next week. Signs that the economy continues to heat up could bolster the case for more hawkish monetary policy and push bond yields higher, weighing on prices.

Barclays analysts expect credit spreads to widen to “recessionary levels” of 200-210 basis points for investment-grade bonds and 850-900 basis points for high-grade debt. yield. Those spreads, which show how much investors are willing to pay for riskier bonds relative to Treasuries, currently sit at around 150 and 460 basis points, respectively.

“Financing conditions are rapidly tightening in the United States and around the world, and economic growth is well below trend. This is generally difficult for businesses and credit spreads. We don’t think this time will be any different,” they wrote.

LIQUIDITY WITHDRAWAL

Even with last month’s rally, investment-grade bonds have posted a total return of -12% year-to-date while high-yield bonds have returned -9%, putting both on track for their worst year since 2008, according to Refinitiv data.

U.S. investment-grade and high-yield bond funds saw inflows of around $9 billion and $4 billion in July, respectively, a month that included deals such as a $10 billion offering by Bank of America and another of 7 billion dollars by JPMorgan. The category saw $67 billion in outflows this year, according to fund flow data from EPFR.

High-yield bonds, less sensitive to interest rate fluctuations, have attracted about $14 billion since the start of the year. The appetite for riskier credit tends to dry up when investors sense that an economic downturn is approaching.

Some investors are also concerned that the Fed’s reduction of its $9 trillion balance sheet, which it launched last month as part of its efforts to cool the economy, could negatively affect credit markets. The Fed already embarked on quantitative tightening in 2017, and investors speculated how the process might affect asset prices this time around.

Matt Miskin, co-head of investment strategy at John Hancock Investment Management, said investors could avoid riskier assets such as corporate bonds as the Fed’s balance sheet reduction helps to tighten conditions. financial resources and contributes to reducing market liquidity.

Greg Zappin, portfolio manager at Penn Mutual Asset Management, said QT was one of the factors that led him to a risk-averse stance in his portfolio.

“It’s a very relevant factor, it’s only the second time we’ve experienced it and it’s happening in a different economic context,” Zappin said.

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