Duration Duration Duration

Duration is more toxic than credit quality, junk bond say

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  The recent widening in credit spreads indicates that duration is a bigger villain than credit quality. Although year-to-date junk bond spreads widened faster than high-grade spreads, junk recorded half of the losses than investment-grade bonds in terms of total return. In 2022, reducing duration to a minimum will be critical while securing an adequate yield amid a rising interest rate environment. Junk bonds remain the only fixed-income assets to provide a solution to the problem. Yet, investors should pay attention to financing conditions, as a sudden rise in real rates could finally provoke a selloff within weaker corporate bonds.


Investors begin to worry that the recent volatility in rates will cause trouble within the junk bond space. Year to date, junk funds have suffered the worst exodus since January last year, while high-grade fund flows were up in a sign that investors are looking for quality as yields rise.

However, fund flows are not providing the whole picture.

Source: Bloomberg and Saxo Group.

According to Bloomberg Barclays indexes, corporate junk bond OAS widened during the first week of the year by 17bps amid a sudden rise in Treasury yields. At the same time, investment-grade corporate spreads widened only 1.37bps. Yet, junk is down only 1.15% year-to-date, while high-grade corporates dropped by 2% in terms of total return. As volatility in the Treasury market stabilizes, we see corporate spreads recover their losses. Today, junk records a loss of -0.6% since the beginning of the year, while quality is still registering a loss of -1.9%.

The conclusion that bond investors can draw from this is clear. Duration will be 2022 big villain, while credit quality will continue to be overlooked as long as negative real yields provide favorable financing conditions.

This point gets more explicit when we compare total junk return by rating. Better-rated junk (BB) dropped faster than lower-rated junk (CCC) because it contains more duration than the latter. Not only, but the bid for higher-yielding corporates, regardless of credit quality, remains strong. Indeed, there is no other instrument in the bond market that can offer a high enough yield to create a buffer against high inflation and rising interest rates. On top of that, helicopter money in 2020 and 2021 improved credit quality within weaker companies, leading S&P and Moody’s to give much more rating upgrades than downgrades last year than ever in the past ten years. 

Like the stock markets, bond investors embrace the TINA (There Is No Alternative) mantra and buy junk, confident that at the first hiccup, the Federal Reserve will step in to rescue the day.

This strategy might work for some time, but it cannot last long. Since the beginning of the year, real rates rose exponentially, with 10-year TIPS going from -1.1% to -0.7% in just eight days. Rising real rates threaten weaker companies because they indicate a sudden tightening of financing conditions. Therefore, they could spell an upcoming increase of downgrades or even defaults in the junk bond space.

It is not improbable since the Federal Reserve is now looking to steepen the yield curve by running off its balance sheet. It's a desperate step that the FED needs to take to avoid an inversion of the yield curve.

What can tell me things are about to go south?

As the Fed prepares to tighten the economy as soon as March, it’s key to understand what could ring the alarming bells before a complete meltdown.

  1. Real yields. Watch real yields rise. Once they break above -0.5%, we are entering a danger zone all the way to 0%
Source: Bloomberg and Saxo Group.

2. HY-IG spread. The spread between junk and investment grade remains within the lowest level since 2007 despite the recent widening in HY spreads. Once it starts to rise above 250bps, it will be time to reconsider risk within your junk positions, as it will be indicating that either (1) credit quality is deteriorating (2) market sentiment is changing, which could send the market into a "taper tantrum" kind of selloff.

Source: Bloomberg and Saxo Group.
Overall, there is no reason to panic right now. Financial conditions remain favorable, and junk continues to be supported. Investors' worst enemy remains duration. Yet, it's essential to consider how monetary policy tightening could change the environment and undermine vulnerable positions.
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