Yields on lower-grade corporate bonds tracked by the Intercontinental Exchange index fell to 8.76% through Monday’s trading, from a recent high of 9.61% on Oct. 13. Investors say they are increasingly confident that interest rates could peak without putting the ability of many lower-rated companies to service their debt in serious jeopardy.
Bonds at all levels have come under fire this year from the Federal Reserve’s efforts to contain inflation, which has fueled the biggest run of interest rate hikes in decades. Inflation and higher rates have reduced the value of the fixed stream of bond payments to investors, driving down bond prices and increasing yields.
Adding to the pain of junk-rated bonds, there are fears that higher rates could lead to an economic slowdown that would hurt the ability of indebted companies to make payments on time, increasing the possibility of defaults.
Over the past month, new data and comments from Fed officials have convinced many investors that an end to rate hikes may be in sight. Figures showing year-over-year inflation slowed to 7.7% in October from 8.2% in September “have been a welcome relief,” Dallas Fed Chair Lorie said. Logan, after their publication.
At the central bank’s November meeting, officials “increasingly focused on the question of when the Committee might slow the pace of future increases,” according to the minutes of the meeting, referring to the Federal Open Market Committee responsible for setting rates.
Meanwhile, rising rates did not cloud the outlook for corporate profitability as much as some investors had feared. As more companies lay off workers and cut forecasts as demand slows, Wall Street analysts still expect corporate earnings among S&P 500 companies to rise 6% this year and another 6% next year, according to FactSet.
“Despite the fact that we think we’re going into a recession in 2023, corporate balance sheets are in pretty good shape,” said John McClain, portfolio manager at Brandywine Global Investment Management. “We don’t see a significant default cycle through 2023 and beyond.”
These factors have helped attract a steady flow of cash into junk bond funds over the past month. Lower-grade debt funds attracted positive net inflows for five consecutive weeks through Nov. 23, adding a total of $13.47 billion during that period, according to Refinitiv Lipper. This is by far the largest series of admissions supported this year.
Additionally, more companies are repaying their debt, a positive signal for junk bond investors who are looking at balance sheets to determine how likely companies are to repay debt on time.
Last week, spam-listed clothing retailer Abercrombie & Fitch said it bought back $8 million of its own debt in the third quarter, along with $8 million in share buybacks. In October, Joel Ackerman, chief financial officer of dialysis provider DaVita Inc., told analysts on a conference call that the company would focus its capital deployment more on reducing its level of debt.
With higher funding costs putting corporate transactions and fundraising on hold, a dearth of new issues has supported junk bond prices this year. At just over $100 billion in 2022, junk bond issuance is expected to fall more than 78% from a year ago, according to Leveraged Commentary & Data.
Despite the recent rally, junk bonds still caused losses for investors over the year, returning minus 11% in 2022, including price changes and interest payments, according to ICE indices. . That’s even better than the minus 15% yields on higher-rated corporate debt.
High-yield bonds have outperformed others largely because in addition to offering higher interest payments, they tend to mature faster than their higher-quality counterparts, said director Steven Foresti. investments for asset allocation and research at Wilshire Advisors. This means that their prices are likely to fall less when interest rates rise.
Mr. Foresti has told his clients that with yields close to 9%, junk bonds offer attractive value. “There is a lot more utility in these investments than even less than a year ago,” he said.
Others are skeptical. Amid the recent rally, junk bonds are offering 4.63 percentage points more yield than Treasuries, up from nearly 6 percentage points in June. In past recessions, this premium, or spread, has often climbed above 8 percentage points as investors demand higher compensation for increasing default risk.
Today, with many investors confident a recession is on the way, junk bond spreads aren’t high enough to make the risks worthwhile for investors, said portfolio manager Saurabh Sud. at T. Rowe Price.
Just as the Fed was slow to react to rising inflation in 2021, the central bank could be slow to ease as the economy cools, he warned, a bleak outlook for very in debt.
“If this creates an environment where fiscal tightening is high, it implies that the risk of a credit crash is high,” Sud said.
