Risky US corporate bond trading has started 2023 on an upbeat note, with investors tolerating smaller premiums to hold low-grade debt as evidence of rising inflation.
Speculative-grade U.S. bond yields have fallen about 0.8 percentage points in the first two weeks of January to slightly more than 8 percent, according to an ICE Data Services index, signaling a rise in debt prices.
The cost of borrowing for the group with the lowest credit quality has fallen even more, according to the Ice gauge of distressed debt, sliding about 3 percentage points to 19.3 percent – a level seen five months ago.
The improvement follows a sell-off in low-grade bonds along with riskier asset classes last year as the US central bank quickly raised interest rates.
This month’s move partly reflects a rally in US government debt, fueled by expectations that the Federal Reserve will ease its stance on aggressive interest rate hikes amid sluggish price growth. The decline in benchmark Treasury yields has increased 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 early January, a sign that investors are betting on a lighter economic backdrop and reduced default risks.
The spread on high-yield US bonds has tightened by 0.5 percent since the end of December to 4.29 percentage points on January 12. The spread for the most depressed junk bonds has decreased by almost 3 percentage points to slightly less than 16 percentage points.
Matt Mish, head of credit strategy at UBS, said inflation has “balanced” has surprised investors “to the downside” recently.
Data showed that the US consumer price index eased for six consecutive months in December, to 6.5 percent.
At the same time, “the growth data on the net can be characterized as mixed” for the world’s largest economy, said Mish. “That’s why I think inflation data, and expectations about how that flows into Fed policy. . . . That’s really what the market is focusing on.”
The new credit spread has come even as the Treasury yield curve — the difference between two- and 10-year government bond yields — remains inverted, which investors typically see as a harbinger of a prolonged economic contraction.
During a short but sharp recession during the coronavirus crisis in 2020, the US high yield spread shot up more than 1,000 percentage points.
“I think it’s very difficult to make a case that we’re going to make it through 2023 without a significant spread,” said Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors.
“I don’t think Treasury rates will drop far enough to cover the loss of a [2, 3 or 4 percentage point] widening,” he added, indicating that default rates are expected to rise.
“If the spread ends tighter at the end of the month it will be one positive data point for the performance of the rest of the year,” UBS’s Mish said.
Fridson noted that the high-yield market “doesn’t have a good track record” of providing reliable signals before recessions.
“It’s typical that people seem to stick around, maybe not too happy, thinking, ‘Well, I’ll get out before everyone else does’,” he said.