Low Asset

Double whammy looms over low-rated corporate bonds

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At the end of a bumpy week for low-rated corporate bonds, it is the Federal Reserve, not the Omicron coronavirus variant, that remains the biggest concern for investors in the asset class.

By now, many debt investors have become used to sharp swings in markets after a flare-up in Covid-19 cases triggers a sell-off. The spread of the new Omicron variant is the latest iteration, and the tired response from glassy-eyed portfolio managers points to the reflexive expectation that debt prices will recover from the latest jolt. They have after every previous Covid setback, after all.

“We see it as a buying opportunity,” echoed multiple bond managers in conversations this week. In other words, the “buy the dip” mantra still holds for many.

Unlike previous shocks, though, this one has arrived just as crisis support measures for markets are beginning to be pulled back.

Fed chair Jay Powell said in testimony to Congress this week that it may even be appropriate to accelerate the rollback of these measures in a bid to combat high inflation, retiring his use of the word “transitory” to describe the upward pressure on prices.

It constitutes a form of monetary tightening — not what one would expect if Omicron was expected to derail the recovery. If Omicron does end up curtailing America’s current economic resurgence, then low-rated bond investors could face a double whammy.

Tighter monetary policy pushes up interest rates, increasing the cost of borrowing for companies and pushing down the prices of existing bonds as they become less attractive.

This typically affects higher-rated debt sooner than lower-quality bonds despite the greater capacity to pay of the issuer. For higher quality debt, base interest rates represent a larger chunk of the overall yield.

The yield on a widely watched index of higher quality, investment-grade corporate bonds run by Ice Data Services has been steadily creeping upwards since August, on expectations that the Fed would begin to wind down its $120bn-a-month bond-buying programme, sapping liquidity from financial markets.

High-yield bonds are usually more resilient to changes in Fed policy. The yields on this debt are based more on an assessment of the higher risk of lending to lower-quality issuers. As such, a lower proportion of the overall yield of high-yield debt represents base interest rates. And rising interest rates are offset by improving corporate fundamentals, pulling down the risk of lending to low-rated companies.

Nonetheless, even before Omicron roiled junk debt just over a week ago, yields had begun to rise in response to the Fed’s expected tapering of bond purchases.

That cracks are emerging in the debt of lower-rated companies is unnerving, especially given the deluge of lowly rated, triple C borrowers that have come to market this year, and the continued weakening of lending standards and investor protections in deal documents.

The recent sell-off means that the yield on an index of triple C rated debt came close to completing a round trip for the year in November, having reached a peak in January of 8.33 per cent, declining to a low in July of 6.28 per cent, before rising nearly a percentage point last month to 8.28 per cent.

Investors are by no means rushing to their panic stations. The yield on Ice’s overall high-yield bond index is still around levels reached last year when euphoria over the first successful Covid vaccine trials dominated the narrative.

Default rates remain low and are expected to remain low next year. And for investors looking for higher returns with interest rates held low across the globe, the US junk bond market remains attractive.

Still, a more cautious tone is setting in, visible elsewhere on Wall Street, too. The gap between short- and long-dated Treasury yields has declined to its smallest since January, signalling slowing expectations for economic growth.

The Russell 2000 stock index of smaller, more domestically focused companies — seen as a barometer for the broader health of the US economy — fell more than 10 per cent this week from its recent peak before a rebound on Thursday.

The Atlanta Fed is still forecasting stellar growth of about 10 per cent in the US for the fourth quarter but markets are always attempting to look further out to where the economy is going, not where it is now.

Some investors warn that the Fed could find itself tightening monetary policy to combat inflation just as the economy begins to cool down. And it is here that the risk of Omicron — even if not the primary risk investors are concerned about — comes into focus. Powell may have to choose whether to tackle inflation or slowing growth. He may not be able to do both.

In such a tug of war environment, monetary policy error, as one bond fund manager put it, is the biggest potential risk heading into 2022.

joe.rennison@ft.com

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