Risky corporate bonds trading in the US have kicked off 2023 on an upbeat note, with investors tolerating a smaller premium to hold low-grade debt as evidence of cooling inflation mounts.
Yields on speculative-grade US bonds have fallen by about 0.8 percentage points in the first two weeks of January to slightly more than 8 per cent, according to an ICE Data Services index, signalling a rise in the debt’s price.
Borrowing costs for groups with the lowest credit quality have dropped even more, according to an Ice gauge of distressed debt, sliding about 3 percentage points to 19.3 per cent — a level last seen five months ago.
Those improvements follow a heavy sell-off in low-grade bonds along with other riskier asset classes last year as the US central bank rapidly boosted interest rates.
This month’s move partly reflects a rally in US government debt, fuelled by expectations that the Federal Reserve will soften its stance on aggressive interest rate rises in the face of slowing price growth. The decline in benchmark Treasury yields has boosted the appeal of low-rated corporate bonds that typically offer higher returns.
The gulf in yields between junk bonds and Treasuries has also narrowed since the start of January, in a sign that investors are betting on a more benign economic backdrop and a decreasing risk of default.
The spread on US high-yield bonds has tightened by 0.5 percentage points since the end of December to 4.29 percentage points on January 12. The spread for the most distressed junk bonds has diminished by almost 3 percentage points to slightly less than 16 percentage points.
Matt Mish, head of credit strategy at UBS, said inflation had “on balance” been surprising investors “to the downside” recently.
Data on Thursday showed that the US consumer price index eased for a sixth consecutive month in December, to 6.5 per cent.
At the same time, “the growth data on net you could characterise as mixed” for the world’s largest economy, said Mish. “Which is why I think the inflation data, and expectations around how that flows through to Fed policy . . . is really what the market is focused on.”
The recent trimming of credit spreads has come even as the Treasury yield curve — the difference between two- and 10-year government bond yields — remains inverted, which is typically seen by investors as a harbinger of a prolonged economic contraction.
When a short but sharp recession hit during the depths of the coronavirus crisis in 2020, the US high-yield spread shot above 1,000 percentage points.
“I think it’s very hard to make the case that we’ll go through all 2023 without some significant widening in the spread,” said Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors.
“I don’t think Treasury rates are going to come down far enough to offset a [2, 3 or 4 percentage point] widening,” he added, pointing out that default rates were expected to rise.
“If spreads finish tighter at month-end it would be one positive data point for rest-of-year performance,” UBS’s Mish said.
Fridson noted that the high-yield market “does not have a great record” in providing a reliable alert well in advance of a recession.
“It’s typical that people seem to stay with it, maybe overstay their welcome, figuring, ‘well, I’ll get out before everybody else does’,” he said.
