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Cracks are appearing in the junk bond market as investors who own some of the riskiest bonds on the market demand higher dividends. It’s not the time to exit high-yield bonds, but investors should pay attention to the warning signs.
The yield on high-yield bonds is now 8.1%, up from 7.22% last month. The rise reflects a sharp rise in yields across the curve, which reached nearly $2 trillion in the fiscal year ended Sept. 30, as investors priced in more inflation from other pressures such as rising energy prices and concerns about budget deficits.
The high-yield market is also showing credit stress, with spreads widening recently to levels not seen since April, according to the St. Louis Fed. Credit spreads are the difference between the yields on bonds and U.S. Treasuries of similar maturities. Widening spreads mean investors view holding corporate bonds as riskier and are demanding higher yields.
Spreads across the high-yield market stood at 315 basis points (bp), up from a year ago but still below the 346 basis points (bp) reached in March. One basis point equals one hundredth of a percent, or 0.01%.
The high yield market consists of bonds rated BB+ by S&P and Fitch and bonds rated Ba1 or lower by Moody’s. The lowest-rated CCC and below cohorts have seen the most movement, with spreads rising dramatically over the past year to around 1,250 bps.
“Blinking yellow”
Michael Arone, chief investment strategist at State Street Investment Management, said the high-yield market is currently “shining yellow,” but “nowhere near red.”
He said with borrowing costs rising, it’s no surprise that investors are demanding more compensation for taking on additional credit risk.
Yields have improved overall. 10 year treasury Earlier this week, it reached its highest level since 2002.
“The bigger question is whether this is just a reassessment of interest rate risk or the beginning of a more fundamental reassessment of credit quality,” Arone said.
He is in wait-and-see mode, as profits are still growing, interest coverage ratios remain strong, and default rates have increased slightly, but not enough to cause concern.
That said, spreads are still low by historical standards, so the starting point for the spread is likely weighing on investor sentiment.
“I think there’s a small margin of error here, and that’s adding to the anxiety level,” Arone explained. “Subtle changes in credit spreads could be concerning because the rewards that investors are receiving for taking on this credit risk are not as overwhelming as they have been historically.”
“Logical crack”
While there may be concerns in some lower-rated markets, the fundamentals for the overall high-yield market are positive.
In fact, credit quality is at an all-time high, with BB bonds accounting for more than 60% of the market, up from 38% before the global financial crisis, said Kelly Gerrity, fixed income strategist at Morgan Stanley Investment Management.
“You’ve got better quality companies coming in, and now with higher interest rates, there’s also more discipline from more indebted companies. It’s actually creating a slightly healthier situation just because the cost of capital is higher,” she said.
The lowest tier of high-yield bonds has always been speculative because of the high default risk of high-yield bonds. So it’s no surprise that these are the companies with the widest spreads, said Colin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research.
He said the overall movement in high-yield spreads was “orderly.” “Are we seeing a crack? I think the crack is a logical crack in the lowest-rated bonds. It’s too early to say it’s spreading across credit markets.”
Furthermore, there is an idiosyncrasy in the movement within spreads below CCC ratings, Gerrity added. Morgan Stanley recently categorized the lowest cohort spreads into two buckets: performing and non-performing assets, defined as spreads above 1,000 bps.
He said the worst-case bad spread is 2,818bps, while the performance bucket, the largest part of the CCC market, is 461bps.
“I feel isolated,” she said. “While we are not necessarily convinced that this situation will resolve itself anytime soon, it does not speak to the overall concern or glimmering of caution in credit markets at this time.”
For now, investors should continue to choose within the higher yield range, Gerrity advised.
“We’re looking for the highest relative value opportunity and we think that exists within the single B tier, so that’s where we’re leaning,” she said.
warning sign
Investors should be concerned if there is a sharp expansion in the broader high-yield market.
However, there is little evidence of stress in the BB cohort. The spread for this group is 194 bps, up from 179 bps a year ago, but the movement is not linear.
“We’re going to focus on what we think are the stronger businesses,” Martin said. “If we start to see that the market is demanding higher spreads there as well, that’s where we’ll be looking to see if the risk is really going up.”
RJ Gallo, chief investment officer of global fixed income at Federated Hermes, said it’s also important to understand that the Federal Reserve is raising interest rates in a strong economic environment. He pointed out that while economic growth has been stronger than expected, the central bank is concerned about inflation due to soaring fossil fuel prices due to the Iran war.
“Given that growth is good as a reason for the Fed to raise rates, you wouldn’t expect high yield to explode, because growth means that earnings are maintained and cash flow and profitability are maintained,” he explained.
Gallo said high yields will be a disaster when the economy heads into a sharp recession.
“That’s when the spread really widens,” he says. “But recessions aren’t guaranteed. So tell me in six months, if the Fed keeps raising interest rates a lot and oil prices stay high for longer, then we’ll probably start to wonder.”
