Expensive Junk Bonds See Sudden Sentiment Shift: Credit Weekly

Upbeat bets on high-yield corporate bonds are beginning to unravel as interest rates are expected to remain high for longer.

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Investors are instead turning back to safer investment-grade bonds, saying junk-rated companies' debt has become too expensive after the recent rally — especially as earnings are likely to deteriorate in an economic downturn. Default rates are also expected to increase.

Oaktree Capital executives, including Chief Investment Officer Bruce Karsh, wrote this week about companies facing “cash crunch” amid slowing growth and rising costs. “We believe cash positions are tighter than today's yield ranges suggest,” they said.

The gap between global investment grade and high yield spreads widened 13.5 basis points this week – the first widening in six weeks – showing the start of a move towards safety. At the same time, money managers have the largest overweight to high-quality versus junk debt in the most recent Bank of America survey since 2009.

It paints a picture of a reversal in sentiment for high yield credit, which has benefited from a rally in risk assets in recent months. Compared to safer bonds since the beginning of last year, until recently they were almost the most expensive in terms of additional spread for riskier bonds.

The shift is happening as markets are alerted to how interest rates are moving. Federal Reserve Chair Jerome Powell this week reiterated that the Fed is not done with the hike, while European Central Bank President Christine Lagarde stressed that there is still some catching up to do. The Bank of England unexpectedly hiked interest rates by 50 basis points on Thursday.

Read more: US HY OPEN: Junk bonds break week-long rally on Powell testimony

This makes yields on safer debt securities more attractive. The yield on an index of global high quality bonds maturing within the next three years has risen so much that at 5.4% it is yielding the same as junk bonds in early 2022.

Steven Oh, global head of credit and fixed income at PineBridge Investments, says the gap between U.S. BBB-rated bonds and BB-rated debt should be at least 50 basis points wider than the current 100 basis point spread to take risk adequately reflect. Ian Horn, a portfolio manager at Muzinich & Co., recommends staying away from single-B rated junk bonds because some of them may struggle to refinance their debt when it falls due. He prefers BBB bonds and high-quality Tier 2 bank bonds.

Even a small fraction of the weaker companies are at risk of failure as borrowing costs rise. Moody's Investors Service expects global speculative company defaults to peak at 5% by the end of April 2024.

Investment grade yields are now offering one of the best entry points for investors since the global financial crisis. That's especially important as Oh and Horn both see the regular income from holding bonds as the main driver of returns for the rest of the year, rather than betting on large price movements.

However, those who move to a higher class run the risk of repeating the experiences of the last two months. A change in tone from central banks later in the year could change the picture again, while junk bonds are also less vulnerable to yield increases compared to longer-dated high quality bonds.

Still, the safety of investment-grade bonds is attractive at the moment. “The Fed may or may not cut rates. You can get some of the highest yields on short-dated bonds that don't default,” Horn said. “It's a cozy place.”

Weekly review

  • According to Bryan Whalen, co-chief investment officer and portfolio manager of TCW Group Inc.'s fixed income group, mortgage-backed securities are “very cheap.”

  • High yield companies lined up to lend at the fastest pace in five months after risk premia fell to their lowest level since the regional banking crisis rocked credit markets in March.

  • Troubled companies are selling assets to ease the pressure from rising interest rates, falling profits and a looming maturity limit.

  • Private equity firms turn to direct lenders rather than banks and the broader credit market to fund small acquisitions for companies already in their portfolios. That's partly because private lenders can circumvent a most-favored-nation clause, which drives up financing costs.

  • Returns on private credit funds are likely to diverge more widely as corporate defaults increase.

  • T. Rowe Price Group Inc., Allspring Global Investments and AllianceBernstein Holding LP are among investors looking for opportunities in longer-dated, high-quality corporate bonds.

  • Commercial real estate firm Unibail-Rodamco-Westfield SE is offering its hybrid bondholders a debt swap ahead of an early redemption date later this year. Companies typically call off this type of debt at the first opportunity, but a rise in refinancing costs has meant it has become prohibitively expensive for some.

  • South Korea's $169 billion sovereign wealth fund plans to invest 25% of its assets in the private equity and credit category, said CEO Seoungho Jin.

  • Lombard Odier's Asian bond boss — a rare bull on Chinese junk — has sold dollar bills from troubled conglomerate Dalian Wanda Group Co. and logistics company GLP China Holdings Ltd. collected.

  • The world's most indebted developer, China Evergrande Group, expects to file a petition in court late next month over its multi-billion-dollar offshore debt restructuring plan. It also plans to release audited financial results for the past two years.

Traveling

  • Natixis SA hired Asif Khan from MUFG Securities where he was Global Head of Collateralized Loan Obligations.

  • John Aylward's credit hedge fund Sona hired Stephen Smith, co-head of Barclays Plc's global leveraged finance syndicate.

  • Former Credit Suisse Group AG banker Matthew Grinnell joined the US arm of Sumitomo Mitsui Financial Group to build leveraged finance.

  • Hilco Corporate Finance recruited Kyle Herman and Sanjay Marken for restructuring consulting in Houston.

  • Schonfeld Strategic Advisors has appointed former Macquarie dealer Toby Kung as Head of Credit for Europe.

  • Cantor Fitzgerald LP hired Ted Anibal and Arthur Tetyevsky of Seaport Global Securities to join its Hybrid/Preferred team.

– With support from James Crombie, Catherine Bosley, Bruce Douglas and Dorothy Ma.

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