Why junk-bonds are moving to their own groove in the pandemic recovery
Inflation scares haven’t created havoc everywhere.
U.S. stocks booked a weekly loss after hot inflation data for April spooked investors bracing for a roaring, but potentially messy economic recovery. Their counterparts in the debt world barely budged.
High-yield, or “junk bonds,” issued by riskier U.S. companies tend to mimic equities when rough patches hit. Lately that correlation has been breaking down.
Here are a couple of potential reasons why.
“Credit generally is going to be correlated to the fundamentals of the economy,” John Yovanovic, head of high-yield portfolio management at PineBridge Investments, told MarketWatch. “We know the fundamentals are going to improve dramatically over the next few quarters.”
This chart shows a steadier rise for high yield since May 2020, while the S&P 500 index gains have been choppier.
“In a pattern that has now become familiar, cash credit markets have been resilient in the face of volatile price action in the equity market,” Lotfi Karoui’s team of credit analysts at Goldman Sachs wrote in a weekly note.
“We continue to expect the equity-credit correlation will remain structurally lower over the near to medium term as strong economic growth expectations, improving balance sheet fundamentals, and supportive policy leave left-tail risk in check.”
In other words, it’s hard to see a catalyst for the sky to fall for junk bonds
without an unexpected shift in the Federal Reserve’s accommodative policy stance, of another outside shock.
That contrasts with stocks, where despite strong first quarter earnings, it’s been getting harder for investors not to worry about hiccups this summer or about the economic recovery already being priced into equity indexes, which ended the week lower, but still near record highs.
Stocks have shot up during the pandemic as trillions of dollars worth of fiscal and monetary stimulus have been unleashed to help shore up financial markets, companies and households. Corporate bond yields, and spreads, have plunged too.
Bond spreads are the level of compensation investors earn above a risk-free benchmark like U.S. Treasuries. Lower spreads imply investors are willing to be paid less to finance companies and other borrowers, even those considered a high default risk.
Junk-bond spreads ended the week near 337 basis points above Treasurys
or roughly 15 basis points wider than the sector’s recent lows of April 8, according to data for BofA Global Research.
“High yield has a lower yield than it used to,” Yovanovic said. “But it’s still relatively higher than other choices.”
He said high yield investors appear to have come to grips with the volatility in U.S. Treasury yields that reared up in the first quarter. “It dawned on investors,” Yovanovic said, that rising long-term yields signaled, “the economy was recovering. Then spreads tightened pretty significantly.”
The 10-year Treasury yield was up nearly 75 basis points on the year through Friday to 1.639%. A wild card would be if long-term yields continue to dramatically climb this year, he said, even as the Fed keeps shorter-term policy interest rates in check.
But after a wave of defaults last year, the few high yield companies still viewed as distressed would likely benefit from the recovery in oil and soaring commodity prices, according to the Goldman team. West Texas Intermediate crude
Many high yield companies also used ultra low interest rates to tidy up their debts, a factor that helped push the distressed segment of the market to 2%, a new post 2008 recession, per Goldman Sachs data.
“If you look at the risk factors for the asset class, it’s not default rates were talking about,” Yovanovic said. “The default rate is going to be really low this year. You’d need to get something coming off the rails with the economic recovery to change my opinion.”