US junk bond sell-off resumes after Fed snaps summer rally

Risky US corporate borrowers are facing a renewed jump in borrowing costs as concerns that further sharp Federal Reserve rate rises will weigh heavily on the world’s biggest economy grip markets.

Yields on US junk bonds have jumped to almost 8.6 per cent from a mid-August low of 7.4 per cent, according to an Ice Data Services index. The rise reflects a significant decline in the price of the debt.

The fresh selling in high-yield bonds comes after a brief summer respite, in which most risky assets recovered somewhat from a dismal first half of 2022. Traders had hoped the Fed would take a softer approach to rate rises, but concerns the central bank will step up its fight against inflation have shattered the calm.

“As this summer of optimism draws to a close, the Fed path and recession fears are returning to the fore,” said Srikanth Sankaran, strategist at Morgan Stanley.

As a result, investors have raced out of funds that buy junk-rated US corporate bonds, with $8.7bn withdrawn from accounts over the past two weeks, according to flows tracked by EPFR. Redemptions in the past week ranked as the sixth-biggest weekly outflow since the coronavirus pandemic rocked US financial markets in 2020.

Line chart of Yield to worst (%) showing US junk bond yields head higher

Lotfi Karoui, a strategist at Goldman Sachs, said Jay Powell’s speech in late August at the Jackson Hole economic summit in which the Fed chair vowed to “keep at it” in the central bank’s tightening of monetary policy to fight inflation spooked investors.

“Powell’s annual speech . . . delivered an unambiguous message that a dovish pivot is not in sight,” Karoui said. “For markets, this means a return to square one as investors readjust their expectations to a growth, inflation, and policy mix that is likely to stay unfriendly for quite some time.”

The rise in junk bond yields reflects an increase in rate rise expectations that have affected the entire US debt market and intensifying jitters about lower-rated companies’ ability to make good on their obligations. Traders now expect the Fed to lift rates to nearly 4 per cent by early next year, up from between 2.25 and 2.5 per cent today.

Column chart of Weekly flows into US high-yield corporate bond funds ($bn) showing Junk bond funds hit with two consecutive weeks of redemptions

The gap between the yields on US junk bonds and ultra low risk US government debt has jumped to slightly above 5 percentage points from 4.2 percentage points in mid-August. It started the year at about 3 percentage points. The widening spread suggests “the growth outlook is getting worse, that the probability of recession is creeping up,” said Ed Smith, co-chief investment officer at Rathbone Investment Management.

Morgan Stanley’s Sankaran noted, however, that while the current level points to a more “stressed market”, it would need to rise significantly further to fully price in recession risks.

Defaults have generally remained low, with many companies having used the period of historically low interest rates in the wake of the coronavirus crisis to decrease their borrowing costs and push back when payments of the original amounts borrowed will come due.

Line chart of US high-yield spread (percentage points) showing Rising spreads suggest markets are more worried about credit risk

However, cracks are beginning to show. There were default events affecting $4.7bn worth of bonds and loans in the US market in August, the third-highest total since November 2020, according to JPMorgan Chase data. The Wall Street bank noted August marked the sixth straight month of default activity exceeding $3.3bn compared with an average of $1.3bn per month from November 2020 to February 2022.

Sankaran added that while the second-quarter earnings season, which provided the most recent snapshot of corporate America’s fundamentals, “was not overwhelmingly negative . . . evidence of weakening demand, shifts in consumer spending and inventory pressures for retailers were abundant”.

The sell-off comes at a poor time for major banks across Wall Street, which are expected to begin pitching tens of billions of dollars worth of bond sales to investors next week. Money managers are paying particular close attention to a $15bn financing package banks led by Bank of America are planning to launch to fund Vista Equity Partners and Elliott Management’s $16.5bn takeover of software company Citrix.

The banks are staring down losses that could exceed $1bn on the deal, which is seen as a bellwether for the terms lenders will demand on new junk debt.


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