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Junk bond jolt marks time on strangely serene year: Mike Dolan


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LONDON — If financial volatility at large is finally being uncorked, the most cossetted assets may be jolted from their slumber.

For most of the 20 months since the pandemic hit, financial assets have been buoyed by waves of government and central bank intervention designed to protect workers and businesses while authorities suspended economic activity to suppress the virus.

Nowhere has that been clearer than in corporate bonds – especially the riskiest speculative part of that market for so-called junk bonds, where many firms worst affected by lockdowns raise cash.

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But a double whammy from the prospect of central bank normalization alongside expiring government supports, together with another wave of new travel and social restrictions from the new omicron variant, jarred investors over the past week.

As U.S. high-yield bond funds saw the biggest outflows in eight months in November, according to Refinitiv Lipper data, junk bond yield premia blew out this week to their widest since COVID-19 hit last year. At -1.0%, average monthly returns were their most negative since then too.

Omicron’s emergence and hawkish central banks did European junk bonds no favor either, with aggregate high yield indices seeing borrowing spreads over regional benchmarks hit their highest for the year.

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If the almost eerie calm experienced in these assets is now disturbed and plays catch-up to the already more restive rates, currency and now equity markets, a very bumpy 2022 is ahead.

Axa Investment Managers’ Gregory Venizelos talks of the “bifurcation” this year between rising volatility in interest rate, government bond and currency markets and relatively care-free stock and credit markets.

So much so, that U.S. dollar junk bonds – adjusted for volatility – actually outperformed the S&P500 over 12 months – in the longest period of calm for high yield spreads since before the global financial crisis in 2007/2008, he added.

On some levels, this low spread volatility and “straight line” yield carry could easily extend into 2022.

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High-yield bonds are less prone to interest rate risk, or duration, than investment grade credit – which has had a more stressful 2021. Earnings growth should stay high for the first half too and flatter current spreads that way.

But with equity volatility now starting to match rates and currency gyrations into year-end, and tremors in credit spreads emerging over the past week too, there will be temptation to cut and run.

Raphaël Gallardo at French asset manager Carmignac sees signs of “exhaustion” in high-yield markets despite their attraction as one of the few areas to escape deeply negative real yields as inflation builds and nominal rates stay capped.

“There is cause for concern because if you look at short-term yields and adjust for forward inflation, real yields here are close to zero too,” Gallardo said.

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“So investors may be embarking on high levels of risk for very low levels of expected returns,” he added. “The price discovery mechanism is not functioning the way it is, the level of expected default rates going forward is likely underestimated.”

‘SHOULD I STAY OR SHOULD I GO?’

The extent to which low junk default rates have been flattered by official support and what happens to so-called ‘zombie’ firms when that gets rolled back has been one of the biggest financial conundrums of the pandemic.

While less central bank largesse should affect investment grade more than junk credits, the combination of this and new COVID-19 waves and variants could unsettle both.

But despite heeding warnings on high-grade corporates, many see a case to stick with junk for a bit longer.

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The pandemic debt picture was complicated. For many of the bigger and safer firms, the scramble for funding last year saw debt net of cash barely budge as much of the cash stockpiles were left unused as earnings bounced back, new debt sales were less necessary this year and debt servicing costs remained low.

The picture was perhaps less benign for junk credits, but still remarkable.

Axa’s Venizelos points out that the global high yield debt stock expanded by almost a third since 2019 but overall coupon payments have only risen by about half that amount.

What’s more, earnings-driven balance sheet repair means net credit ratings are set flip positive for the first time since last year’s blowout and ‘rising stars’ migrating up to investment grade indices are starting to outnumber ‘fallen angels’ going the other way.

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With related junk defaults peaking last year at 9% in the United States and 5% in Europe, credit rating firm Moodys’ default rate forecasts of just over 2% for the year ahead are less than where even today’s narrow spreads would imply.

Bank of America’s global credit outlook for 2022 sees another punchy 4-5% total returns in U.S. junk bonds for the year ahead – preferring re-opening sectors like travel, real estate, financials and gaming over telecom, media, pharma or packaging names.

Answering its own question “Should I stay or should I go?,” it opts for the former.

While rates volatility or Chinese credit worries could yet rankle, the rest of the junk picture still looks positive. “All in all, this makes for a still-benign backdrop for credit losses: good news for high-yield credit and especially good news for leveraged loans.”

(by Mike Dolan, Twitter: @reutersMikeD Additional reporting and charts by Sujata Rao, Karen Pierog and Patturaja Murugaboopathy Editing by Mark Potter)

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