Is the junk bond market too bullish on a soft landing in the economy?

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Investors looking for riskier corporate bonds as a “canary in the coal mine” to help gauge the chances of a US recession may want to think twice.

US bonds with “junk,” or speculative, credit ratings showed further signs of optimism this summer about the Federal Reserve’s ability to cool inflation and stage a soft landing.

A pullback in commodity prices helped galvanize the junk bond rally, while a robust job market helped battered cyclical sectors, eased fears of a looming recession and brought investors back to the transactions.

“A lot of people were sitting on a crate,” said Matthew Kennedy, senior portfolio manager at Angel Oak Capital Advisors. That quickly changed with signs of slowing inflation, plus a lack of new junk bond issues and a deluge of maturing coupons helping to fuel demand.

But this week’s rally also sparked debate about whether investors were too giddy too soon, especially with inflation and the pace of Fed interest rate hikes still unpredictable.

“There is still a lot of uncertainty in terms of the economy,” Kennedy said, adding that the central bank’s 2% annual inflation target could be difficult to achieve. “And if it stabilizes at 3% or 4%? I think the verdict is out on that again.

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Cyclical rally

US stocks and bonds sold off dramatically in the first half of the year as the Fed announced its intention to use interest rate hikes quickly to cool inflation from 40-year highs.

The summer stock market rally surprised, with the S&P 500 SPX index,
-1.29%
rebounding around 17% from its mid-June low, before starting to tumble this week.

Similarly, junk-rated bonds posted a record rally this summer. Spreads, a key risk indicator, fell to around 437 basis points above the TMUBMUSD10Y Treasury risk-free yield,
2.961%
from a roughly two-year high of 600 basis points in July, according to the ICE BofA US High Yield Index.

As with equities, recent bullish betting has also boosted cyclical junk bond sectors (see chart), including gaming, leisure and entertainment.

Cyclicals get a big boost from June lows

Goldman Sachs Global Investment Research, Bloomberg

Even so, Goldman Sachs credit analysts said they “believe it’s too early to get constructive on cyclical junk bond sectors and remain broadly cautious in the latter part of the year,” in a weekly customer note.

They expect commodity prices, oil in particular, to rebound late in the year, with inventory pressures and geopolitical factors “crowding out” discretionary consumer spending. US benchmark crude price CL00,
-0.91%

CLU22,
-0.90%
ended the week at a loss, settling at $90.77 a barrel.

Related: Diesel and natural gas prices remain high, fueling food price inflation

The strength of the U.S. labor market could also produce a “possible headwind to growth,” they said, while noting its potential impact on the final federal funds rate.

Individuals often gain exposure to junk bonds through exchange-traded funds, the largest iShares iBoxx $High Yield Corporate Bond ETF HYG,
-1.02%
ended the week flat, but was still up 1.1% from the previous month, according to Factset.

Kennedy at Angel Oak said his team favors companies with strong balance sheets and limited rollover risk. They also remain overweight in energy, a large exposure to junk bonds, saying global production is still not meeting quotas and US shale drillers are not ramping up production due to labor costs. work higher in a tight job market.

“I think it’s being selective and very grassroots oriented,” he said.

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