The price of risky US corporate debt has risen sharply this year as investors bet the Federal Reserve will control inflation without triggering a devastating recession.
Yields on U.S. junk bonds — debt sold by businesses with poor credit ratings — have fallen more than one percentage point since the end of 2022, according to the Es Data Service index, trading at an average of 7.97 percent. The decline indicates a sharp rise in prices.
Subsequently, the gap between waste yields and US government bonds has narrowed more than 0.8 percentage points to less than 4 percentage points – the first time it has sat below that level since last April.
Shrinking “spreads” have dampened expectations of reduced debt for the $1.8tn low-grade corporate bond market. It also represents continued betting that the Fed will be able to relax its aggressive tightening of monetary policy sooner than the central bank has indicated – reducing the likelihood of a sharp economic downturn.
“I think the market is really priced in for a soft landing,” said John McClain, portfolio manager at Brandywine Global Investment Management. “It’s a combination of January euphoria, which has led to higher equity prices, and higher equity prices have attracted high-yield credit spreads.”
Evidence of cooling US inflation has helped boost mood, with December’s consumer price index reading falling for the sixth month in a row, falling to 6.5 percent from a peak of 9.1 percent in June.
Next, futures markets are pricing in expectations that US government borrowing costs will rise to a peak of 5.1 percent in July, before falling to 4.8 percent by the end of the year.
That bet comes even as Fed officials themselves have indicated they expect rates to remain above 5 percent in December, and after the latest jobs report signaled a hotter-than-predicted labor market.
US employers added 517,000 new roles in January, compared with a forecast of 185,000, despite the central bank’s efforts to cool the overheated economy.
“The macro picture has always been positive, with inflation falling in sequence,” said Kelly Burton, high yield portfolio manager at Barings. “Job vacancy data [suggests] we are not going into a deep recession anytime soon.
Burton also highlighted technical factors driving the junk bond rally this year, with spreads and issuance improving from a weak base.
“We’re coming up on a year with almost no issuance because companies can tolerate volatility,” he said. “I’m more than a starting point that has attracted interest [high-yield] as well as technical background”.
Dominique Toublan, head of US credit strategy at Barclays, said 2023 has started with people having “money to invest” because they have been “defensive for a long time” and there is “little [fear of missing out] going on”.
At the same time, he said, “those who have been short” – betting on the improvement in credit prices – “decided not to be short anymore, so they removed the hedges”.
High-yield spreads may continue to tighten in the short term, Toublan said. But he expects them to spread by the end of this year, “quite significantly from where we are”.
Marty Fridson, chief investment officer at Livian Lehmann Fridson Investors, also predicts the yield gap between junk bonds and low-risk Treasuries will widen. “You still have a lot of signs pointing to a recession,” he said.
The spread could increase by up to two percentage points, Fridson added, “because the expectation is starting to change from ‘everything is fine, the Fed will pivot, we will have a soft landing’.”
“Historically, high yield markets have not anticipated recessions very well,” he said. It is “not unprecedented” for the market to “ignore the flashing yellow lights”.
For Brandywine’s McClain, the “conflicting data” in recent weeks “provides cover for the Fed to continue its hike in additional rate hikes followed by what we believe is a long pause”.
He predicts a scenario where the US avoids a recession “so much more”. However, he said there is a chance the US economy will pick up inflation later this year which could create new challenges for the central bank.