The US Federal Reserve building in Washington
The US Federal Reserve has lifted rates from near zero to a target range of 5-5.25 per cent in just 14 months © Reuters

The resilience of the $1.4tn US junk bond market is puzzling investors worried about higher interest rates and an economic downturn.

Despite concerns over the health of the world’s biggest economy, with some market indicators pointing to recession, yields have fallen since highs last autumn while spreads over government debt have tightened in recent months.

That has surprised some investors and prompted warnings that the market could suffer a one-two punch further down the road as a downturn hits earnings just as issuers have to contend with higher interest rates.

Current high-yield spreads “are an ongoing mystery”, said Marty Fridson, chief investment officer at investment firm Lehmann, Livian, Fridson Advisors. “There’s really no evidence of the market expecting recession at this point.”

Central to the relative strength of the market is the scarcity of supply due to meagre levels of new borrowing, helped by a flurry of ratings upgrades supporting prices for existing debt.

The limited high-yield issuance follows a dealmaking frenzy during the height of the Covid-19 crisis, when companies took advantage of ultra-low interest rates to borrow cheaply and push out payment dates.

Since then, inflation has soared, the Federal Reserve has lifted rates from near zero to a target range of 5-5.25 per cent in just 14 months and the US Treasury yield curve has inverted, a potential indicator of a recession.

Column chart of Issuance YTD for 2023 and previous years showing Meagre new borrowing in the US junk bond market

“Issuers really have the upper hand,” said Fridson. “They don’t have large portions of their debt coming due within the next year or two and are not facing an actual need to refinance.”

This explains the only slight increase in US junk-rated issuance this year to $67.1bn, according to data provider Dealogic, compared with roughly $50bn for the same period in 2022 when the market in effect shut down as the Fed launched aggressive interest rate rises and Russia launched its full-scale invasion of Ukraine. Full-year corporate high-yield issuance in 2022 came to just $91bn, down from $404bn in 2021.

Sales of new bonds have picked up since April this year as the banking turmoil eased. But less than one-third, or $20.4bn, of total junk issuance since January 1 has been new fundraising rather than refinancing, according to Dealogic, the lowest proportion since 1999.

“The vast majority of supply that has hit the market this year has been deployed towards refinancing — and so you’re not really adding more debt on balance sheets, you’re just replacing the old debt,” said Lotfi Karoui, chief credit strategist at Goldman Sachs. 

“There’s a technical in the market that’s overwhelming everything,” said Sean Feeley, high-yield portfolio manager at Barings, “and that’s a shrinking high-yield bond market” — meaning “a lack of new issues that can’t keep up with natural run-off”.

The US junk bond market has shed roughly $100bn in value over the past year, dropping from $1.48tn to $1.37tn, according to Ice Data Services.

Column chart of Monthly 'new' high-yield bond issuance ($bn) showing Supply is lower even as issuance has perked up in spring

These factors have helped average junk bond yields stabilise at just below 9 per cent, according to an Ice and Bank of America index.

That level — reflecting the interest due on corporate debt — is roughly in line with a recent peak of just above 9 per cent in March, when the collapse of Silicon Valley and Signature banks piled pressure on the broader financial sector.

But spreads, the premium junk-rated companies pay to borrow over government debt, stood at 4.58 percentage points this week — the “historical non-recession median” for junk bonds, according to analysis by Fridson — compared with more than 5 percentage points in March.

On top of relatively scant new issuance, a stronger than anticipated jobs picture has also underpinned junk bond prices, said Adam Abbas, co-head of fixed income at Harris Associates, with data signalling persistent labour market tightness.

Abbas added that rising Treasury yields had been supportive too, because “duration has now become painful once again” — referring to fixed-income assets whose prices are more sensitive to changes in interest rates. In contrast, less sensitive, “shorter-duration” high-yield bonds have been “a relatively nice place to hide”.

Line chart of Option-adjusted spread (percentage points) showing Junk bond spreads have tightened from recent peaks

Still, he said he was surprised at the resilience of the junk bond market.

In addition, the market has been depleted by companies moving up the credit quality ranks.

The volume of “rising star” debt that has achieved investment-grade status this year reached an unexpectedly high $56bn as of May 11, according to analysis by Goldman Sachs. The number of companies dropping down to junk territory has increased — but volumes are smaller, at just $16.6bn. 

However, some traders and analysts expect the high-yield market eventually to reflect macroeconomic reality.

Goldman’s Karoui said his team was expecting “some kind of a normalisation” in the second half. While they are not predicting a “material deterioration”, he pointed to a “broader macro reality — and that’s slower earnings growth and rising interest expenses.

“At some point, macro will catch up.”

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