Investors brace for turmoil in the US corporate bond market

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Investors have rushed to the derivatives market to protect corporate bond portfolios from possible selling off, as they grapple with the growing risk that the recent stock price slump will ripple to the bottom. corporate debt.

According to data from the International Swaps and Derivatives Association.

“The market is much more nervous than it was at the start of the year,” said Viktor Hjort, global head of credit strategy at BNP Paribas.

Investors fear that rising inflation will usher in a period of tightening Federal Reserve policy, pushing interest rates higher and hitting the valuation of riskier stocks and bonds.

So far, corporate bond markets have remained relatively quiet, equities have sold off this year. The yield difference between risky bonds and US Treasuries has yet to surpass December levels, when Omicron fears rose, according to Ice Data Services. However, activity in the derivatives markets shows that below the surface, investors are bracing for the possibility that wider cracks could yet appear in credit as well.

Hjort said he believes the credit cycle has turned, meaning the positive economic backdrop will no longer benefit corporate bond investors. Continued economic growth will encourage the Fed to tighten monetary policy and push companies toward shareholder-friendly activities like mergers and capital spending, Hjort says, which are likely to weigh on corporate bond prices.

In addition to CDS indices, investors turned to credit options, where soon-to-expire contracts – used to protect investors against the possibility of a short-term price decline – rose in value. “It’s a sign of acute risk aversion,” Hjort said.

According to data from Markit, some of the largest exchange-traded funds that track corporate bonds have also seen high short activity, a bet that also pays off if prices fall. Some bank traders said they saw clients move hedges from equity markets to credit markets.

In another sign of decline, funds that buy US high-yield bonds suffered outflows for four straight weeks, leading to year-to-date outflows of nearly $11 billion. On Jan. 18, investors withdrew $1.3 billion from a widely watched high-yield exchange-traded fund — known by its ticker symbol HYG — marking its biggest one-day outflow since February 2020, according to data from Bloomberg.

Fund flow column chart (in billions of dollars) showing investors are getting money from US high yield bonds

Ion Analytic pulled a bond deal from the market in January, citing volatile market conditions, according to people familiar with the deal, underscoring market sentiment.

“We don’t see this very often,” said a credit investor who had been briefed on the deal. “It’s a sign that money lying around looking for things to buy is low.”

Net positioning in credit default swap indices – the difference between those buying and those selling – has shifted markedly towards investors who are short to hedge against lower prices.

“It signals that more people are reducing risk and adding hedges,” said Calvin Vinitwatanakhun, strategist at Citi.

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