Junk-rated debt rode out the storm, though prices may still be too high in current business cycle phase
As stocks ended their worst week in two years in early February and yields on benchmark 10-year U.S Treasury notes briefly moved toward their highest levels in four years, bond investors headed for the exits.
For the week ended Feb. 14, U.S. high-yield mutual funds and ETFs recorded outflows of about $6.3 billion, following about $2.7 billion the previous week, according to figures from Thomson Reuters Lipper. This was the fifth consecutive week of outflows for high-yield, or junk bonds, for a total of $15 billion over that time frame. The outflows last week were eclipsed only by an exit of $7.1 billion in the week ended Aug. 6, 2014, according to LeveragedLoan.com.
Despite the recent volatility in the equity market, spreads on high-yield bonds, or the risk premium investors pay over safe U.S. Treasury securities, widened far less than in previous bouts of equity market volatility. High-yield bonds, which are riskier than investment-grade corporate debt, tend to follow trading and sentiment in the stock market.
Based on a five-day moving average of the Cboe Volatility Index (VIX), which was only 9.4 for the period ended Jan. 8, but rose to 31.5 as of Feb. 9, high-yield bond spreads’ five-day average only widened from 342 basis points over comparable Treasury securities to 366 basis points, according to Moody’s Analytics. By contrast, when the five-day VIX moving average rose from 12.1 to 32.2 during a five-week period from late July to late August 2015, the average high-yield bond spread widened considerably from 499 basis points to 603 basis points.
The difference this time around is mostly chalked up to expectations that fewer companies will default in the current environment of steady global economic growth and above-average corporate earnings. Moody’s currently estimates that the U.S. high-yield default rate may decline from January 2018’s 3.2% to 2.0% by January 2019.
Back in the third quarter of 2015, Moody’s was projecting a climb in the high-yield default rate from 2.3% in July of that year to 3.4% by August 2016. That estimate came amid expectations for lower pretax operating profits, as metals prices and crude oil prices were off by roughly 24% and 50%, respectively, year-on-year for the period through July 2015.
In addition to the muted price movement in the high-yield sector in early February, the overall bond market outperformed stocks. While the S&P 500 index fell by 10.2% from Jan. 26 through Feb. 8, the Bloomberg Barclays U.S. Aggregate Bond Index fell by only 1.0%, according to LPL Research’s analysis of Bloomberg data.
Potential Headwinds Ahead?
Research from Charles Schwab notes that the recent volatility marked a repricing of risk to more realistic levels, though without the pain of an economic downturn, or fundamental imbalance in the global economy. Caution is warranted, though, as there may be more near-term turmoil ahead as markets adjust to the outlook of higher budget deficits in the U.S., withdrawal of central bank support and the prospects for higher inflation.
Corporate debt overall has benefited in recent years from aggressive and accommodative monetary policy from global central banks following the financial crisis. Steady economic growth and investors seeking higher yields and greater returns outside of safer sovereign debt have also supported corporate bond prices and driven yields lower.
Now, corporate debt may be at a crossroads as central banks are removing support and interest rates are rising.
The quality of corporate debt has also deteriorated in recent years. S&P Global Ratings said in early February that 37% of corporate borrowers had a debt-to-earnings ratio of more than five times in 2017. That’s up five percentage points from 2007 before the financial crisis.
While improving corporate earnings and cash flow may offset some risks associated with higher debt, a weaker dollar, faster-than-expected economic growth and higher commodity prices could spark inflation, and lead to a “material repricing of risk and faster rise in interest rates,” S&P Global says.
Moody’s also notes caution, saying that high-yield bond spreads currently appear to be too thin with or without elevated stock market volatility. That is based on a Moody’s model which takes into account VIX, the average expected high-yield default frequency, and overall economic activity and related inflationary pressure from the Chicago Fed National Activity Index.
When including the recent VIX index of 19.8, the model predicted a 460 basis point midpoint for high-yield bond spreads, compared to the actual 381 basis points over Treasury securities that high-yield bond spreads were as of Feb. 14. The reading suggests that high-yield spreads are more likely to widen than narrow, barring significantly lower readings for expected defaults and VIX, and a jump in the national activity index.
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