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U.S. Credit Risk Continues to Decline in Low-Yield Environment; But Bumpy Road Ahead for Some Sectors

You would have to go back to mid-2007 to find credit spreads and risk premium for U.S. high-yield bonds trading at less than 2.30 percentage points over U.S. Treasury securities. The historically low interest-rate environment across the globe has benefited these securities as investors and fund managers seek to boost returns.

Stimulus measures by central banks, particularly in Europe and Japan, have driven yields on less risky securities so low – even below zero for safe government debt – that institutional investors and fund managers have had to seek returns further down the risk spectrum. Among the more popular areas has been double-B-rated bonds issued by U.S. companies, two rating notches below debt that’s considered triple-B, or investment-grade, by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings Inc.

The spread on double-B-rated U.S. corporate debt fell to 2.26 percentage points above benchmark Treasuries as of the market close on June 19, according to Bank of America Merrill Lynch’s index that tracks these securities’ performance versus an adjusted Treasury yield curve. That was the lowest level since July 2007.1

The continuing flow of money to high-yield bonds and U.S. corporate credit in general comes amid higher leverage in sectors that include energy, real estate and utilities, and a retail industry undergoing seismic shifts from the incursion of online sales and consumer spending habits.

From a macro view, performance of below investment-grade corporate securities, also known as junk bonds, is typically driven by the business cycle. Slowing economic growth, a leading indicator of sorts for how these bonds might perform, however, doesn’t appear to be immediately on the horizon. The consensus view of U.S. economists for the probability of a recession during the next 12 months currently stands at 16%, according to a Wall Street Journal survey of economists.2

These bonds, though, generally lose some of their luster during an interest-rate tightening cycle – the Federal Reserve increased short-term rates for the fourth time in the current cycle on June 14. Borrowing costs tend to increase in a rising rate environment, pressuring companies with higher balance-sheet leverage that might need to refinance existing or maturing debt.

Overall, the global search for yield presents challenges for bond investors across the risk spectrum and investor class, whether you’re investing in bond mutual funds, exchange-traded funds or managing billions of dollars, euros and yen that need to generate returns to match longer-term liabilities. And as the performance of U.S. high-yield debt appears to make clear, there isn’t much bang for the buck available in the current environment.

Consider that the amount of negative-yielding global sovereign debt rose to $9.5 trillion as of May 31, up from $8.6 trillion as of March 1, according to Fitch Ratings Inc.The global rating agency notes that negative-yielding sovereign debt has been declining since November 2016, but challenges remain. Insurance companies and buy-and-hold investors, for example, have significant asset allocations to medium- and longer-term sovereign debt that will likely generate far less income when the maturing debt is reinvested in lower-yielding fixed-income securities.

Despite the lack of return investors are getting for the risk premium they’re paying, money continues to flow into the U.S. corporate bond market – even as U.S. stock market indexes continue to hit new highs in what’s considered an overvalued market.

In turn, institutional managers have had to search for yield to achieve their target returns. Data from the Investment Company Institute shows that about $8.14 billion of net new cash went into bond mutual funds for the week ending June 7, up from $1.8 billion the previous week – much of the new cash flowing to investment-grade, multisector and global funds. High-yield bond inflows were $430 million, compared with $453 million of outflows during the week ending May 31.4

All risky credits aren’t created equal, however. Rating agencies continue to sound the alarm on the U.S. retail sector. Moody’s forecasts a 6.7% and 6.8% default rate, respectively, for speculative-grade retail and apparel credits by April 2018.Fitch forecasts that its railing 12-month default rate for institutional term loans int he retail sector will rise to 9.0% by year-end, up from 2.7% in early June. Fitch says a filing by heavily indebted Sears Holding Corp. would swing the rate higher by about 4.0%.6

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Citations.

1-BofA Merrill Lynch, BofA Merrill Lynch US High Yield BB Option-Adjusted Spread© [BAMLH0A1HYBB], retrieved from FRED, Federal Reserve Bank of St. Louis: https://fred.stlouisfed.org/series/BAMLH0A1HYBB (accessed June 20, 2017).

2-The Wall Street Journal Economic Forecasting Survey: http://projects.wsj.com/econforecast/#ind=recession&r=60 (accessed June 20, 2017).

3- “Fitch: Neg-Yielding Sov Debt Rises to $9.5T, Challenges Remain,” Fitch Ratings Inc.: https://www.fitchratings.com/site/pr/1025047 (accessed June 20, 2017).

4- Long-Term Mutual Fund Net New Cash Flow, Investment Company Institute. (Data is for the week ended June 14, 2017).

5-“Moody’s: Ranks of distressed retailers set to keep growing amid industry shift,” Moody’s Investors Service: https://www.moodys.com/research/Moodys-Ranks-of-distressed-retailers-set-to-keep-growing-amid–PR_367907?WT.mc_id=AM~RmluYW56ZW4ubmV0X1JTQl9SYXRpbmdzX05ld3NfTm9fVHJhbnNsYXRpb25z~20170607_PR_367907 (accessed June 20, 2017).

6-“Fitch: Gymboree Filing Lifts US Retail Loan Default Rate to 2.7%,” Fitch Ratings Inc.: https://www.fitchratings.com/site/pr/1024997 (accessed June 20, 2017).

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