Yields have fallen to about 8% from 9.4% in early November but some analysts are concerned by high funding costs
The junk bond market has become “complacent” over the risks facing corporate America after a sharp drop in debt funding costs, some investors and economists warn, with high interest rates and a possible economic downturn still posing a threat to low-grade, highly indebted borrowers. A feverish rally across financial markets on hopes of rapid interest rate cuts later this year has sent companies’ borrowing costs plunging in recent months.
Even after a partial reversal in the first few days of January, the average yield on an index of US junk bonds still hovers at roughly 8 per cent, according to Ice BofA data, compared with 9.4 per cent as recently as early November.
Yields move inversely to prices. That drastic shift in sentiment has fuelled concerns among some strategists and investors that market pricing has reached overly-optimistic territory. Companies must still contend with funding costs much higher than they were just two years ago, the lingering possibility of an economic downturn that hurts sales and profits, and rising wage costs. “The market is trading as if zero interest rates have come back — and they have not,” said Torsten Slok, chief economist at investment firm Apollo.
The so-called spread, or premium, over Treasury notes paid by junk-rated borrowers to issue new debt has also fallen since November 1, from 4.47 percentage points to 3.5 percentage points. That is well below the median figures of 4.55 percentage points and 8.39 percentage points respectively for historical non-recession months and recession months going back to 1996, according to analysis by Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors.
“I do think that the market is a little complacent,” said Kevin Loome, a high-yield portfolio manager at T Rowe Price. He added that the rally had been driven by many fixed income investors simply finding 8 per cent yields on sub-investment-grade bonds — and even higher yields on loans — “really attractive”. The decline in financing costs reflects growing conviction among investors that the Federal Reserve has completed its cycle of monetary policy tightening, after jacking up interest rates from near-zero in early 2022 to a range of 5.25 to 5.5 percent in a bid to curb inflation. Investors’ convictions grew in mid-December when Fed policymakers gave their strongest signal yet that rate rises were over and pointed to three quarter-point cuts in 2024.
In response, investors poured money into US government bonds and riskier asset classes. “The fourth quarter [of 2023] was a shock to everybody about how strongly the market rallied,” said Loome. A survey on Thursday by the International Association of Credit Portfolio Managers, whose members include big banks and fund houses, showed that many participants “believe the euphoria seen in global financial markets the last two months of 2023 was overdone”.
Respondents think that “while credit conditions look better today, the fight against inflation will probably take longer than expected”, the survey added. Those concerns among credit market participants come as new data this week showed US corporate bankruptcies reached a 13-year peak in 2023, according to an S&P Global Market Intelligence report, with 642 filings in total and 50 in December alone.
The biggest bankruptcies of last year included retailer Rite Aid, helicopter ambulance group Air Methods and co-working company WeWork. “Although investors expect the [Fed] to cut interest rates as early as March, companies will still have to contend with relatively high interest rates and robust wage growth in the near term,” S&P’s analysts wrote.
“The run-up in bankruptcies and default rates last year is a very important reminder that the cost of capital matters,” said Apollo’s Slok. There are “still a lot of companies that were created during the ‘free money’ period, that will remain vulnerable to the cost of capital staying high”, he added. Investors and analysts also highlighted an apparent contradiction between the futures market’s expectation of almost six US rate cuts this year and the corporate bond market’s optimism over the outlook for junk borrowers.
While the Fed’s projection of three cuts signals a belief that it can achieve a “soft landing” — quelling inflation without inducing a recession — the need for more cuts would typically reflect a greater deterioration in economic conditions. Such a scenario would, in turn, potentially cause further pain for lowly-rated US companies with already weak cash flows.
“I do think that markets are complacent,” said Slok, “because the other two scenarios — either a hard landing or no landing [no downturn in the economy] — are still not unlikely. “The [central bank] would not cut six times unless the economy is slowing quite sharply,” he added. “If the Fed is cutting six times . . . What are fundamentals going to look like? What are earnings going to look like?”