One of the odd things about the recession fears since December is that spreads on junk bonds have not risen. Usually, junk bonds sell-off when there are recession fears, as they are the riskiest credits and likely to suffer the worst downturns. However, the opposite has happened in junk, with spreads to investment grade very tight. In fact, investors are picking up so little extra yield in junk bonds, that in many cases they are not even worth the risk. Spreads are tied for their narrowest since the Financial Crisis at just 60 basis points.
FINSUM: The last time spreads got this tight was last October, right before the market tanked. Warning sign.
It is time to get out high yield. The sector has been seeing heightened fears for months, and prices have performed so well in the first two months of the year, that there is little value left. High yields returned 6.4% in January and February after the market came to a virtual standstill at the end of 2018. Part of the reason for the outperformance is that investors are demanding less spread to Treasuries, a fact that has not carried over to the investment grade market.
FINSUM: The pendulum has swung too far, and investment grade bonds now appear a much better value than high yield.
High yield had a very bleak run to finish 2018. The asset class went over 40 days without a single sale as the junk credit market seized up. However, it has made a comeback in a major way. The first five weeks of 2019 saw a staggering 5.25% gain in the Bloomberg Barclays US Corporate High Yield Index. New issues were quite oversubscribed (more than double), and the general mood has completely shifted.
FINSUM: The Fed backing off on rates sure makes a difference! It is interesting the market reacted this sharply given that high yield is relatively more insulated from rates. In our view, the turnaround is largely a relief rally that the Fed won’t push the economy into a recession.
There are currently a lot of fears about corporate credit’s ability to sink the economy and markets. There has been an absolute massive surge in issuance since the Financial Crisis, and a great deal of that issuance happened in credits just on the bottom fringe of investment grade. And while a good amount of that debt may founder and sink into junk, it won’t be enough to hurt the economy much. The reason? It is because US households have not increased their leverage significantly in recent years, which is likely to prove a saving grace for the economy. Growth in household debt has been lower than inflation, a sign of relative health.
FINSUM: While corporate credit can get markets in trouble, so long as the American consumer is not deleveraging, things will probably not get too bad in the wider economy.
The junk bond market may be coming back from the dead. The “December doughnut”, as it is being called, is now in the past, and the frozen market finally thawed this week with the first new junk bond sale since November. The market had gone 41 days without a sale until Tuesday, when $4 bn of new issuance went through.
FINSUM: A 41-day freeze and then 4 sales in one day totaling over $4bn. Demand was so high the companies were able to raise more than expected. Maybe the worst is behind the high yield market?