Worst is yet to come for U.S. credit markets, say investors in poll

(Bloomberg) – The ugliest year ever for U.S. corporate bond investors is set to get even uglier — and they only have the Federal Reserve to blame.

As the central bank raises interest rates at the fastest pace in decades, nearly three-quarters of people who responded to the MLIV Pulse survey said monetary policy tightening is the biggest risk facing is facing the corporate debt market. Only 27% were more worried that business bankruptcies would pile up over the next six months.

The findings underscore the bittersweet outlook for fixed income investors who have been hit in the first half by the largest losses since at least the early 1970s. The survey included responses from 707 investment professionals. investment and individual investors.

On the one hand, they don’t think the troubled times are over, with more than three-quarters anticipating that yields this year will hit new highs against Treasuries. But, at the same time, a majority expects the decline to be relatively limited. They predict that the spread – a key indicator of the additional compensation demanded for perceived risk – will remain well below the levels seen during the Covid crash of March 2020 or the recession triggered by the housing market downturn.

“There are definitely a lot more downsides, or risks, to expanding than where we are now,” said Kurt Daum, senior portfolio manager at USAA Investments, a franchise of Victory Capital.

Corporate bond yields rose slightly relative to Treasuries during the selling waves that swept through fixed income markets this year. This spread on investment grade corporate debt reached as high as 160 basis points in July, according to the Bloomberg index, before receding slightly.

But the relatively muted anticipated spread increases show that investors expect the corporate finance market to avoid the kind of stress that followed the 2007-2009 recession, when investment-grade yields jumped over 600 basis points above Treasuries. In March 2020, this gap reached almost 400 basis points, prompting the Fed to intervene to ensure that a lack of available credit does not deal another blow to the economy.

The outlook likely reflects the strong position many companies find themselves in after profits surged on the back of pandemic-related stimulus and two years of low interest rates. Despite speculation that the United States is heading for a recession, the Labor Department announced on Friday that hiring rose unexpectedly in July, the most in five months, underlining that the economy remains strong despite the aggressive tightening of the Fed’s monetary policy.

Credit risk measures for investment grade and high yield bonds continued to tighten on Monday. The longest streak of declines in a month signals an easing of concerns over the credit outlook.

Some 86% of survey respondents said companies are better positioned to weather a recession than they were in 2008. That’s partly because many companies refinanced debt after the Fed reduced rates in 2020.

Still, strong balance sheets shouldn’t be enough to prevent further losses, especially for junk bonds, which would be more sensitive to an economic downturn. Yields likely haven’t peaked yet and could top nearly 9% at the end of June, respondents said.

According to John McClain, high-yield portfolio manager at Brandywine Global Investment Management, such risk means that some bonds, such as those with the CCC rating level, among the lowest of junk status, are not as attractive as higher-rated securities. .

“We urge extreme caution in the CCC segment,” McClain said. “Investors should take on some duration and some credit risk, but too much of either is a recipe for disaster.”

Nearly half of survey participants said they expect equities to outperform corporate debt over the next six months. Just over a third prefer higher quality debt, more than double those expecting better gains from junk bonds. This would mark a break with the trend so far this year, when junk bonds have outperformed as shorter maturities and high coupon payments have provided a buffer against price declines caused by rate hikes in the Fed.

USAA’s Daum said the change may reflect the fact that many junk bonds are rated on the higher spectrum of the scale than in previous periods.

“The high yield market has become much more high quality – with BBs more interest rate sensitive – over the past three to four years,” he said. “For this reason, the rate impact is going to be more pronounced in high yield than it has been historically.”

Rising borrowing costs and an uncertain economic outlook, meanwhile, are expected to keep M&A activity low through the end of the year, according to most participants. Buyouts involving private equity firms fell sharply after a record 2021 as bankers’ underwriting appetite for debt waned amid losses.

The world’s largest investment banks recently disclosed a nearly $2 billion hit from distressed leveraged buyout funding.

The survey also showed that more than 60% of respondents expect China’s offshore bond defaults will not decline in 2023 compared to this year. These debt defaults hit a record high amid a broader debt crisis in the country’s housing market. The coming weeks could bring more pain.

“China’s rolling 12-month overseas default rate could rise further to 6.5% from the current 6.2% if two of 589 issuers miss an interest or principal payment in August, in our scenario,” Bloomberg Intelligence wrote in a report.

Subscribe to MLIV surveys on NSUB MLIVPULSE. To see the full results of this survey, go here.

(Updates with Monday’s price movement in the ninth chart, link to full results last.)

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