Pressure is mounting on the riskiest corner of the US junk bond market

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U.S. corporate bonds sold by poorly rated companies have fallen, signaling growing concern among lenders that searing inflation and higher interest rates are starting to hit borrowers most vulnerable to an economic downturn.

Bonds rated triple C or lower, the lowest rung on the rating scale, have returned negative 2.8% since late April, according to an Ice Data Services index. The performance contrasts sharply with a 1.3% gain for double-B rated debt, the highest quality segment of the junk bond market.

The sharp divergence follows a period of relative outperformance in triple-C rated debt, with the shift reflecting sour sentiment among investors over the outlook for the US economy and the health of US businesses already beginning to deteriorate.

Ken Monaghan, high-yield portfolio manager at Amundi US, said the selloff had been particularly harsh on companies missing analysts’ expectations for first-quarter financial results, mimicking strong stock market revaluations.

“What is clear is that the markets – stocks and [corporate debt] — have little tolerance for companies whose earnings “fall short” of forecasts or expectations,” he said. “And there are quite a few triple C credits that have done just that.”

ATM maker Diebold Nixdorf and pharmaceutical company Bausch Health are among a large number of companies that will see a sharp revaluation of their debt following their profits.

Earlier this year, corporate bond markets proved more resilient than equities to rising inflation and the Fed’s plan to raise interest rates to combat it. In May, that began to change, with falling triple-C debt prices suggesting jitters about the prospects for these companies, unlike higher-rated issuers better able to weather an economic downturn.

By the end of April, triple C-rated debt had lost 7.7% of investors for the year, but still outperformed higher quality double B bonds, which were down 8.9%. That dynamic has now changed, with triple-C rated bonds down 10.2% year-to-date and double-B debt down 7.7%.

Selling in recent weeks briefly pushed the index’s average triple C bond to outperform government bonds, or “spread,” by more than 10 percentage points, a common definition of a bond in difficulty.

Yields have since declined and prices have started to recover over the past week, but triple Cs still lag their higher quality counterparts.

Despite the higher yield offered to traders buying the debt, some investors have warned that the uncertainty ahead is clouding the investment case for lending to such poorly rated companies.

“The Triple Cs have lagged in this rally and we need economic stability before we can buy comfortably again,” said John McClain, portfolio manager at Brandywine Investment Management. “You don’t want to get your hand stuck in the cookie jar, even if the returns look attractive.”

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