A person walks in front of the Federal Reserve building
Expectations that the Fed will bring in a third consecutive 0.75 percentage point interest rate rise in September have eased © Al Drago/Bloomberg

One of the riskiest corners of global financial markets has made an unprecedented recovery in the past month, with prices of junk bonds rebounding as investors bet that the Federal Reserve’s efforts to tame inflation will avoid triggering a deep recession.

The amount of US bonds trading at levels signalling severe investor concern has dropped rapidly over the past five weeks, in a reflection of increased optimism from investors about the state of the US economy.

Just 6.2 per cent of high-yield bonds are now trading at distressed levels, compared with 11.6 per cent on July 5, according to analysis by Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors.

Investors had backed away from US high-yield corporate debt earlier this year, fearing that aggressive interest rate rises by the Fed would force the world’s largest economy into a protracted slowdown, hitting the country’s weakest companies hardest.

But signs that the pace of price growth may be steadying — with inflation data last week coming in lower than forecast — have contributed to a recovery in the price of those assets.

“Over a strikingly short interval, high-yield investors [have come] around to believing inflation is sufficiently under control that the Fed [will] not have to hike interest rates dramatically enough to trigger a deep recession,” said Fridson. “Time will tell whether they were correct in changing their views on that matter.”

US junk bond spreads have fallen back from recent highs

A lack of demand before the rebound in junk bond prices had pushed up the premium investors received for holding high-yield bonds relative to government benchmarks, also known as the spread. The amount of bonds trading with a spread of 10 percentage points or above, a sign that they are distressed, more than doubled from January to May.

“Credit, like equities, is a simple animal,” said Michael Hartnett, chief investment strategist at Bank of America Global Research. “As interest rates were going up and corporate earnings were going down, the first six months of this year was an environment where spreads widened dramatically.”

The rocky conditions prompted some companies to postpone planned borrowings, as central banks withdrew their support for debt markets and inflation damped demand.

But several data releases have suggested that inflation has stabilised in the US economy, meaning expectations that the Fed will bring in a third consecutive 0.75 percentage point rate rise in September have eased.

A renewed sense of optimism about the economic outlook has sent traders back into debt markets. Money has been pumped into investment grade, high yield and emerging market debt funds in recent weeks, after sustained outflows since January, according to flows tracked by EPFR.

Weekly flows into debt funds

With banks delaying planned junk bond sales until after the summer holiday in the US, investors keen to increase their holdings have instead had to gobble up existing debt. Yields on junk-rated US corporate bonds have fallen from an average of 8.94 per cent at the end of June, to 7.45 per cent on Friday.

That fall has been driven largely by a drop in the premium investors demand to lend to lower-rated companies compared with the borrowing costs secured by the US government, rather than by a broader decline in yields. The spread has tightened from 5.99 percentage points on July 5 to 4.25 percentage points on Friday.

Most striking is the pace of this “extraordinary” turnround, said Fridson. It has previously taken at least four months for the spread on the Ice Data Services high yield index to move from 6 percentage points to the current level of 4. The recent drop has taken just over a month, Fridson’s data show.

“Without a sense of inevitability of a near-term recession, investors are predisposed to take a bullish view of any good news,” he said, although some traders remain reluctant.

Gabriele Foà, a portfolio manager at Algebris Investments, said conditions for the corporate bond market were likely to improve further. “This is the tip of the iceberg of what credit can do . . . the levels were crazy and priced for a very big storm. Now they’re not priced for a very big storm but they’re still quite cheap.”

But Adam Abbas, the co-head of fixed income at Harris Associates, cautioned that when debt issuance accelerates later this year, pressure could once again build on junk bonds just as investors are confronted with weakening economic data.

“There needs to be a fair degree of scepticism built into credit analysis,” he said. “A dovish pivot from [Fed chair Jay] Powell, one good employment report and [softer than expected rise in consumer prices], those are certainly good. But the verdict is still out for us.”

Further inflation and jobs data will be published before the Fed’s rate decision next month. Signs that inflation is creeping up again or a larger than expected interest rate rise could push more bonds back into distressed territory.

The longer-term outlook means that analysts are wary of predicting a new bull market for credit. “If you believe corporate earnings are going up and interest rates are going to come down — winner, winner chicken dinner. If, like myself, you think it’s not going to be easy as that, the expected returns don’t look as attractive,” said Hartnett.

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