Duration is more toxic than credit quality, junk bond say

Duration is more toxic than credit quality, junk bond say

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

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.

Quarterly Outlook

01 /

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.