It is finally happening—riskier junk bonds are seeing outflows as investors shy away from the lowest rated credits. Junk bonds have been coated in Teflon for the most part, with the riskiest bonds rallying for several months. But recently, alongside recession fears, investors have been more anxious about how such credits might fare in a downturn. Accordingly, spreads between CCC-rated bonds and BB-rated bonds have jumped to 8%, the highest level since 2016.
FINSUM: This makes a lot of sense, and is one of the more logical moves in the high yield market we have seen in some time.
The broad expectation is that rate cuts will boost all bonds. To some degree this is likely true. However, not all bonds will be affected to the same degree. For instance, safe bonds—think investment grade corporates and Treasuries—have likely already seen most of the gains they will. But high yields are a different story, as they are much more likely to see a decent rally, as lower borrowing costs are a bigger boon to those companies and the cuts themselves will help sustain the economic cycle, which is more important for them than for ultra-safe companies.
FINSUM: This seems to be pretty good analysis. This rate cut has been widely projected and safe bonds have already seen gains, so junk may be the biggest beneficiary.
On the one hand the market looks very healthy (new all-time highs every day), but if you look more deeply there are some signs of dysfunction that appear as though they may spill out into the biggest indexes. Demand for risk assets looks quite weak. Consider for instance that the Russell 2000 is hurting even as large caps rise. Similarly, junk bonds are not doing well despite the seeming risk-on environment. Both of those developments show that liquidity is lacking. “Small caps are more sensitive to liquidity issues, both good and bad”, says a market strategist.
FINSUM: The weakness is small caps and junk bonds shows that more investors are sitting on the sidelines right now, but that does not necessarily mean trouble more broadly.
American investors seem almost conditioned to ignore the rest of the world. Over the last decade that has been a pretty good plan as the US recovery and markets have had a Teflon coating that resisted global downturns. However, rates market in Europe is sending some grave warning signals. Try this on for size: several European junk bonds are now trading at negative yields. Yes, you read that correctly, investors are paying for the privilege of holding junk in Europe.
FINSUM: This is not some ultra-safe Germany sovereign bond that has negative yields. We are talking run-of-the-mill EU junk bonds having negative yields. That is a big warning sign.
The dovishness from the Fed has been bullish for most of the debt market, with sovereign yields falling and corporate debt getting a boost. However, the riskiest corner of the market, triple C junk bonds, have been left out, with the group falling by 1.5% since May. Triple B bonds, by comparison, were up. The odd part about the losses is that signs of an interest rate cut are usually very bullish for junk bonds because they would mean lower interest burdens for the companies. That said, anxiety about the economy is high enough that such benefits were negated.
FINSUM: This whole situation makes sense in that the downside risk of a sinking economy is greater than the upside of lower interest rates for this subsector. Thus, the bonds are losing. In other parts of the credit spectrum, the risk-reward balance is different.