For many months there has been a great deal of fear about the threat of BBB bonds falling into the “junk” category. The whole fear is based on the idea that as the economy slows, this huge group of companies would get downgraded and there would be forced divestiture, sending bond prices strongly lower. However, the opposite has happened. Over the last few months, BBB bonds done nothing but strengthen. In fact, the spread between BBBs and Treasuries just hit a 52-week low, showing investors renewed faith in what is the largest segment of corporate bonds.
FINSUM: Unsurprisingly, the price growth has led to a bunch of new issuance. It is important to remember that though prices have risen, the risk of a recession and downgrades is still very much there.
For many years Pimco was the undisputed leader in bonds. While that reputation may now be arguable given Bill Gross’ departure, Pimco is still undoubtedly highly respected. Therefore, their warning this week is worrying. The firm says it is shunning corporate bonds because of the big risk of a quick fall in prices. The firm’s CIO, Dan Ivascyn, says “The credit sector has been well behaved but if people begin to really fear recession, we can see underperformance quickly … this is the sector most prone to overshooting on the downside”. Pimco is also worried about Treasuries as they see no further room for a rally and instead are favoring agency MBS.
FINSUM: Total debt has grown hugely and a lot of it is of borderline credit quality, so a real downturn in economic expectations could lead to a lot of selling and downgrades. We tend to agree with Pimco here.
If you look at some of the areas hardest hit by fears over the economy and the trade war, there is cautious optimism starting to show up. One of the best examples of this is the corporate bond market. Investors have been pulling money from the stock market and sticking it in bonds. They appear to be unworried about high debt levels or the possibility of default. In this move, there is an underlying faith that the US economy will stay solid, otherwise credit-worthiness would be seriously in question. Spreads to Treasuries are very low too, further reflecting the optimism.
FINSUM: It seems like the market is worried that stock valuations are tapped out, but that there may not be a significant downturn. In such a case, corporate bonds look like a good bet.
Ever since the stock market’s then peak in January 2018, bonds and stock have had a very close relationship. Equities have been tracking the performance of the investment grade bond sector. When yields rose late last year, stocks plummeted. The opposite is happening this year, and in that change lays a predicament for shares. Yields have fallen so deeply this year, and equity prices risen so high, that it appears unlikely stocks can rise much further as the benefits of lower rates have already been fully priced in.
FINSUM: While we are generally incredulous of these types of arguments, we cannot help but feel a confluence of circumstances (an earnings recession not the least of them) are coming together in such a way that equities seem likely to have a correction.
More some time now, bonds have been sending worrying signals to investors. The huge plunge in yields has been seen as a warning sign that the economy may be headed south. However, more recently, fixed income is sending more comforting signals. In particular, the recent narrowing of corporate bond spreads. Bond spreads had been rising for some time, but have leveled off recently, showing fixed income investors are not as worried about the economy and corporate performance. The overall spread is still well below where it was in the 2015-2016 growth scare.
FINSUM: The leveling off of spreads is a good sign that some stability is coming back to the market.