US junk bonds surge on the economic soft landing bets.
Prices for high-risk US company’s debt have increased dramatically this year, as investors bet that the Federal Reserve will bring inflation under control , without leading to a disastrous recession. The yields of US junk bonds, which are debt issued by companies with poor credit ratings, have decreased by more than one percent since the close of 2022.
This is according to the Ice Data Services index, which is trading at an average 7.97 percent. The drop is due to a significant price increase. The gap between the yields of junk bonds and the yields from US Treasury bonds shrunk by over 0.8 percentage points, to just under 4 percent point for the first time that it’s been lower than the level since April.
The decreasing “spread” suggests a decrease in expectations of defaults on debt for this $1.8tn lower-grade market for corporate bonds. Also, it is a sign of continued betting in the belief that the Fed can be expected to relax its tightening monetary policy faster than it has suggested — thus less likely to trigger an economic recession that is severe.
“I believe the market is set for the possibility of a soft landing” stated John McClain, portfolio manager at Brandywine Global Investment Management. “It’s been a mix of January’s euphoria which has resulted in rising equity prices and the higher prices for equity have brought down high yield rates of credit.”
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The evidence of cooling US inflation has helped boost optimism as December’s consumer price index dropped for the sixth time in a row. It dropped to 6.5 percent from 9.1 percent in June. Futures market prices are predicting that US public borrowing rates will increase to 5.1 percent in July, and then fall to 4.8 percent at the close in the calendar year.
Those bets come even as Fed officials themselves have indicated they expect rates will remain above 5 per cent in December, and after the latest jobs report signaled a hotter-than-predicted labor market. US employers created 517,700 new jobs in January, which was higher than expectations of 185,000 despite the Central Bank’s attempts to slam cold water on an overheated economy.
“The general picture of the economy has certainly increased, and inflation is falling in a sequential manner,” said Kelly Burton, the portfolio manager for high yield at Barings. “The jobs data alone suggests that we’re not headed towards another recession in the near term.” Burton also highlighted the factors that triggered this year’s rally in junk bonds in which spreads and issuance increased from a low base.
“We had just completed a year that saw very little issues because firms were able to sit and watch the volatility pass,” she said. “I believe it’s more of this starting point that’s created interest in high yields and the technical context”. Dominique Toublan, US head of credit strategy at Barclays told the thestarbulletin that 2023 started with people having “money to put into investments” due to having “been cautious for some period of time” and “a tiny bit of [fear of losing out]”.
In the same way Toublan explained “people who were in the short ” — or betting on price increases in the credit market — “decided no longer to go short any more which is why they stopped hedges”. The spreads for high yields could continue to tighten in the near-term, according to Toublan. He predicted they could widen towards the end of the year, “quite significantly from where we are”.
Marty Fridson, chief investment officer at Livian Lehmann Fridson Investors, has also predicted the gap that exists between yields of junk bonds as well as low risk Treasuries to grow. “You are still seeing a lot of indicators that point to an economic recession” the analyst said. Spreads could grow by as much as 2 percent, Fridson added, “as the expectation shifts from ‘everything’s fine’ to ‘the Fed is going to change its course, we’ll have”a soft land’.”
“Historically, the high yield market hasn’t predicted recessions very efficiently,” he said. It’s “not uncommon” when the market is “ignoring those flashing green lights”. According to Brandywine’s McClain”the “conflicting data” in recent weeks “provides security to the Fed to go on its current path of rate hikes, followed by what we believe to be an extended time pause”.
He predicted that a scenario in which the US does not enter recession was “becoming increasingly likely”. He also said that there was a good likelihood that the US economy could see an increase in the rate of inflation later this year that could pose new challenges to the Central Bank.