The financial markets are full of practical adages that sometimes but not always work, or that are broadly true but flawed when applied to a particular situation.
One is that stock pickers are optimists and bond investors are pessimists, making the bond market a better predictor of future troubles.
When you buy a company’s stock, you’re (to put it simply) bet on positive outcomes for the company that will add value. So optimism.
Normally, when you lend money to a company, you only bet on one outcome; that the company will pay you back. The main thing threatening you with getting your money back is a company that is performing very poorly. That’s becoming a focus for bond investors. So pessimism.
Such pessimism can be useful to the rest of us. The bond market, and particularly the high-yield bond market, which lends money to riskier companies, is usually one of the first to back down when economic conditions deteriorate enough to threaten corporate balance sheets.
With everything worrying investors right now – from Russia’s invasion of Ukraine to runaway inflation and a restrictive Federal Reserve taking the punch from investors by tightening monetary policy – they should keep a close eye on the high yield bond market . But in the last few periods of stress it really hasn’t moved. Instead, the stock market responded best.
Take this year. In January, the S&P 500 slid into correction territory — defined as a move down more than 10 percent from its recent high. Meanwhile, high-yield bonds fared much better. The yield spread between high-yield bonds and US Treasuries, a measure of the risk of lending to private companies vis-à-vis the government, increased slightly but remained well below any sign of distress. Why weren’t loan investors more concerned? Why aren’t they still?
That’s probably because volatility in stocks this year has not been about fundamental weakness in the economy, but rather about a downgrade of expectations of a Fed rate hike. If that’s true, the loan sent the right signal: that basically everything is still fine.
However, concerns about economic growth are widespread. The US yield curve inverted this week, with long-dated bond rates falling below shorter-dated bonds. This is seen as a classic indicator of a recession, as it implies that longer-term interest rates need to be cut to stave off an economic downturn. Rates markets are also forecasting that the Fed will have to cut rates in just over a year after aggressively raising them, pointing to fears that attempts to stamp out high inflation will stifle economic growth.
Still, the high yield bond market is largely baffled.
There are explanations. Analysts are noting a number of actions that suggest the high yield bond market is less risky than it used to be. For example, low interest rates have allowed companies to secure cheap credit, increasing the likelihood that they will continue to service their debt. Maybe the market just isn’t as recession-prone as it used to be.
“Most companies have a large buffer between current economic conditions and something that could significantly affect their ability to pay down loans — so stocks almost have to move first,” said Peter Tchir, global macro strategist at Academy Securities.
Matt Mish, a credit analyst at UBS, believes there will be tension in the credit market, which has been used by private equity firms to fund aggressive corporate buyouts. Data from S&P Global shows that the share of low-rated, single B and below corporate bonds has shrunk from around 80% of the high yield bond market in 2000 to just under 50% today. In contrast, the same share of the credit market has grown from 50 percent to almost 80 percent.
But even here, stress is unlikely to emerge early, as the vast majority of syndicated loans are held by structured investment vehicles called secured lending commitments, which tie up investors’ money and face less pressure to sell loans.
Are these shifts in financial markets obscuring once tried-and-true indicators of future turmoil? Possibly. However, the most obvious conclusion remains that the risk of a recession is simply low for now.
Consumer balance sheets remain strong overall. The job markets are tight. If companies can weather inflation — and the Fed’s response to it — things might be fine. S&P raised its default forecast to 3 percent by the end of the year. That’s still very low. For now, it appears that the high yield market is poised to shake off current macro concerns. Perhaps there are some optimists in the bond market after all.
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