Head of Fixed Income Strategy
Summary: The junk bond market has proved resilient despite the aggressive Federal Reserve's hiking cycle. High-yield bonds have outperformed investment-grade peers both this year and last year. However, things are about to change. A decelerating economy, a high interest-rate environment, and higher labor and commodity prices will pose a sensible threat to weaker companies. High-yield corporates looking to raise debt face interest payments 50% higher than the average coupon they are paying now. Although redemptions are increasing only in the second half of next year, cash-strapped companies might be unable to raise cash to finance existing obligations, increasing the chances of defaults on interest payments in lower-rated junk. Even if the junkiest of junk begins to default, the chance for credit spreads to widen broadly is high as credit markets are tightly correlated. Within this scenario, we remain defensive, favoring quality and short duration.
Rising interest rates, a weakening economic outlook, and March's SVB hiccup have not hindered junk bond returns this year.
According to Bloomberg Barclays indexes, US high-yield bonds returned 4.54% since the beginning of the year, while high-quality bonds returned only 3.2%. Even in 2022, the fast rise in rates has been more detrimental to quality than junk, with investment-grade bonds recording a loss of -14.10% versus -10.35% in the junk bond space.
The truth is that weaker companies have been fortunate in the aftermath of the Covid pandemic:
However, things are changing fast, and companies with weaker balance sheets face a much more uncertain future.
While the economy is decelerating, labor costs are rising together with commodity prices. Economic data show that demand is waning, pointing to upcoming negative earnings in the year's second half. Such an economic backdrop is building up for a profit squeeze, translating into wider spreads for the lowest-rated corporate bonds. However, bond markets are highly correlated. Therefore, even if the junkiest of junk is affected, the potential to spread to other parts of the credit market is almost inevitable.
How long can junk continue to outperform quality?
As the Federal Reserve prepares to tighten the economy further, the happy-go-lucky attitude of junk bond issuers might abruptly end.
Last week, investors might have received an early warning that junk is about to become toxic.
The spread between high-yield and investment-grade bonds widened for the first time in six weeks. Although the spread remains well below 300 basis points, within the range it was trading in before the pandemic, the circumstances have dramatically changed. Indeed, rates are today double what they were in 2019, and the Federal Reserve is preparing to hike rates further rather than cutting them. Not only that, but central banks also look intentioned to keep rates higher for longer, putting risky assets under even more pressure.
The solid economic backdrop kept the spread between high-yield and investment-grade corporates relatively stable last year. A fast increase in benchmark rates has damaged more high-quality credits rather than junk. But this time, deteriorating economic and corporate fundamentals will weigh on weaker companies, causing the spread between quality and junk to widen.
Financing costs have been rising quickly, but not as much to put junk at risk. Currently, US junk corporate bonds pay, on average, a coupon of 5.9%, which is roughly 280bps below their current average yield. That means that, on average, if high-yield corporates were to refinance their debt today, they would have to pay on average 50% more in interest payments. As operating profits deteriorate, it is safe to assume that junk bond spreads will widen, increasing their refinancing costs further.
The good news is that by refinancing their debt following the 2020 pandemic, corporates have moved redemptions further in the future. Hence, they may not need to raise debt. According to Bloomberg data, only 10% of the debt issued by those corporates belonging to the Bloomberg Barclays US High Yield index is maturing by the end of 2025. Refinancing might become a problem only in the second half of 2024, as volumes of redemptions will begin to rise.
Yet, higher funding costs might limit the financial flexibility of cash-strapped companies that need to raise debt to pay pre-existing obligations, resulting in defaults on their coupon payments.
Because credit markets are highly correlated, if the junkiest of junk begins to falter, the widening of spreads will quickly spread across the whole credit space.
Junk bonds have, on average, a much shorter duration than high-grade bonds. The current duration on high-yield bonds is 3.5 years compared to 7.10 years for investment-grade peers. It follows that junk bonds are pricing on the most expensive part of the yield curve, while investment grade corporates can take advantage of long-term lower yields.
Moreover, the risk of a recession is bearish for lower-rated corporate bonds, while it can be positive for highly-rated credits as they become an alternative to safe havens. As the yield curve steepens amid such a scenario, junk bonds will continue to suffer as investors fly to safety. At the same time, falling rates will help investment-grade bonds’ rate component to outweigh their negative credit spread component.
Overall, we remain defensive. We see more value in government bonds and quality corporates as uncertainty increases credit and default risk.
Fallen angels in fixed income are those bonds that were originally issued with an investment-grade rating and have since been downgraded to a high-yield rating due to the issuer's adverse circumstances.
The best example is Ford Motors' bonds, downgraded to junk during the pandemic. The bonds now have a Ba2 rating from Moodys and BB+ from S&P. Ford senior bonds with three years maturity (US345397D260) offer a yield of 6.75% in yield and pay a coupon of 6.95%. Another example is Travel + Leisure, rated now Ba3 and BB- by Moddys and S&P, respectively, after being downgraded to junk in 2017. The bonds with April 2024 (US98310WAP32) pay a coupon of 5.65%, offering an overall yield of 6.7%.
If the portfolio's capital amount is insufficient to guarantee proper diversification, buying into specific junk bonds can be risky amid a deteriorating macroeconomic outlook.
In that case, funds might enable investors to take broad exposure to the junk bond market while diversifying within this space. It’s fair to note that when you buy a corporate bond, you lock in its yield if you hold the security until maturity. Your investment will be sensitive to rates only if you wish to sell the bond before the notional comes due. Yet, if the company defaults on debt, you may lose all or part of your invested capital.
While your investment may still be affected by the default of one or more ETF holdings, the risk of losing all your capital is reduced to a minimum as the income you will receive and the value of the ETF will track several bonds. Yet, as interest rate rise and corporate spreads widen, the value of the ETF might fall, and you cannot lock in the yield like in a cash bond. Yet, maturing securities will be reinvested into higher-yielding bonds, increasing the income profile of the fund.
Please find below a list of ETFs that might help take exposure to the junk bond market:
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Head of Fixed Income Strategy