Risky US corporate borrowers are facing a renewed rise in borrowing costs amid concerns that further sharp rate hikes by the US Federal Reserve will weigh heavily on the world’s worst-performing markets.
U.S. junk bond yields have risen to nearly 8.6 percent from a mid-August low of 7.4 percent, according to an index by Ice Data Services. The increase reflects a significant fall in the price of the debt instruments.
The renewed selling in high yield comes after a brief summer break, which saw most risky assets recover somewhat from a dismal first half of 2022. Traders had hoped the Fed would take a softer approach to rate hikes but fears the central bank will step up the fight against inflation have shattered the calm.
“As this optimistic summer draws to a close, Fed stance and recession fears are coming back to the fore,” said Srikanth Sankaran, strategist at Morgan Stanley.
As a result, investors have fled funds buying junk-rated US corporate bonds, with $8.7 billion withdrawn from accounts over the past two weeks, according to flows tracked by EPFR. Last week’s redemptions were the sixth largest weekly outflow since the coronavirus pandemic rocked US financial markets in 2020.
Lotfi Karoui, a strategist at Goldman Sachs, said Jay Powell’s speech at the Jackson Hole economic summit in late August, in which the Fed chairman vowed to “stick with it” on the central bank’s monetary tightening to fight inflation, scared investors.
“Powell’s Annual Speech . . . sent a clear message that a dovish turn is not in sight,” Karoui said. “For markets, this means a return to zero as investors adjust their expectations to a growth, inflation and policy mix that is likely to remain unfriendly for some time to come.”
The rise in junk bond yields reflects an increase in rate hike expectations that have impacted the broader US debt market and growing nervousness about the ability of lower-rated companies to meet their obligations. Traders now expect the Fed to hike rates to nearly 4 percent by early next year, after a rise of between 2.25 and 2.5 percent today.
The spread between US junk bond yields and US ultra-low-risk Treasury yields has widened to just over 5 percentage points from 4.2 percentage points in mid-August. He started the year at about 3 percentage points. The widening range suggests “the outlook for growth is deteriorating, that the likelihood of a recession is increasing,” said Ed Smith, co-chief investment officer at Rathbone Investment Management.
However, Morgan Stanley’s Sankaran noted that while current levels suggest a “tighter market”, they would need to rise significantly further to fully price in recession risks.
Defaults have generally remained low as many companies have used the period of historically low interest rates in the wake of the coronavirus crisis to lower their borrowing costs and defer payments on amounts originally borrowed.
However, cracks are beginning to show. According to data from JPMorgan Chase, the US market defaulted on $4.7 billion in bonds and loans in August, the third-highest total since November 2020. The Wall Street Bank noted that August was the sixth month in episode with over $3.3 billion in defaults, compared to an average of $1.3 billion per month from November 2020 to February 2022.
Sankaran added that the second-quarter earnings season, which provided the latest snapshot of US corporate fundamentals, “was not overwhelmingly negative. . . Evidence of weaker demand, shifts in consumer spending and inventory pressures for retailers abounded.”
The sell-off comes at a bad time for big Wall Street banks, which are expected to start selling tens of billions of dollars worth of bonds to investors next week. Money managers are paying particular attention to a $15 billion financing package that banks, led by Bank of America, are planning to fund Vista Equity Partners and Elliott Management’s $16.5 billion acquisition of software company Citrix.
Banks are forecasting losses that could top $1 billion, which are being seen as a guide to the terms lenders will demand for new junk debt.
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