This segment of the corporate bond market issues a warning that investors should not ignore.

US stocks just cemented their worst start to the year in more than half a century. But as the slowdown in the US economy becomes increasingly difficult to ignore, the market for high-yield corporate bonds, often referred to as “junk bonds,” a Wall Street nickname for corporate debt. with less than stellar credit ratings. a warning flashes.

At the close of markets on Thursday, the spread on the Bloomberg High Yield Corporate Bond Index, a measure of the risk premium that investors who hold the bonds included in the index demand, had reached its highest level since July 2020. Included in the index, companies must have a credit rating of “BB” or lower from Moody’s Investors Service or S&P Global Ratings.

Even credits belonging to oil and gas companies, which have long made up a sizable portion of the index (recently, they accounted for about 15%) have taken a hit since the beginning of the year due to the Federal Reserve’s decision to raise its target for the fed funds rate at 1.5 percentage points since it began its rate hike cycle in March. While these loans have outperformed many of their peers in other sectors due to rising oil and gas prices, rising borrowing costs have still weighed on prices.

Ironically, the reason high-yield bonds have sold off in recent days is the same reason government bonds, such as US Treasuries, have risen: escalating fears The recession is prompting investors to shed risky assets like junk debt and stocks in favor of a “safe haven.” assets such as the US dollar and government bonds.

“High-yield credit spreads are widening greatly because the market has begun to fear that high inflation will force the Fed to tighten monetary policy even more aggressively, pushing the economy into a recession,” he said. Gennadiy Goldberg, Senior US Rates Strategist at TD Securities.

“It’s the same reason Treasury yields have fallen in recent days, as markets have begun to fear that the Fed’s very aggressive rhetoric will actually rein in inflation, but at the expense of economic growth,” Goldberg added. .

On Thursday, investors were faced with more signs of an economic slowdown. A reading on consumer spending came in below economists’ expectations, while the Federal Reserve Bank of Atlanta’s latest estimate for second-quarter GDP growth was -1%. If that estimate turns out to be correct, it would mean that the US economy has already descended into a technical recession, which is defined as two consecutive quarters of economic contraction.

There’s a good reason why investors should pay attention to high-yield credits now: Market specialists view high-yield credit spreads as a leading indicator of the economy, as investors in these credits are especially sensitive to anything that could hurt business. ‘ ability to pay its debts. High-yield bond ETFs have already seen their biggest outflows on record during the first half of the year, MarketWatch previously reported. Bond yields move inversely to prices, rising as prices fall.

“When you look at high yield credit spreads, they tend to be a leading indicator, especially of how investors perceive the economy. Investors are demanding much higher yield, much more compensation, to invest in these bonds given the risks that are increasing. There is less faith today in the ability of these companies to keep up with their debt payments than there was a few months ago,” said Collin Martin, fixed income strategist at the Schwab Center for Financial Research.

Another problem with increasing returns is that they tend to be self-reinforcing: Increasing returns increase the cost of refinancing a company’s debt, starving companies of capital during tough economic times, when they need it most. As Charlie Bilello, founder and CEO of Compound Capital Advisors, noted in a tweet, high-yield credit spreads topped 10 percentage points during each of the last three recessions.

And rising credit spreads are also a problem for the underlying US economy. Since this class of corporate borrowers employs millions of Americans, CEOs and CFOs typically respond to higher borrowing costs and other indications of an impending recession by laying off workers and delaying investments.

“If you’re a CEO or CFO, you’re looking forward to what your corporate earnings outlook looks like, you see input costs, labor costs and borrowing costs rising, and given market expectations of more slow, the demand for your product is likely to decline. So what do you do to successfully run your business? You don’t spend more on capital expenditures, you don’t hire more employees because you know your earnings could stay flat or even go down,” Martin said. “It’s a pretty negative outlook right now.”

Rising spreads have yet to translate into higher defaults, but that could change soon. Both Moody’s and S&P, the two main providers of credit ratings for corporations and governments, expect the default rate for high-yield borrowers to rise to 3% or more over the next 12 months, according to their projections.

And with the Fed expected to raise its fed funds rate target by another 150 basis points or more before the end of the year (while continuing to shrink its balance sheet), companies will quickly find their borrowing costs rising sharply, even falling. double within a year.

With inflation, labor costs and the cost of servicing debt on the rise, management will likely be forced to tolerate cutbacks like job cuts. In fact, the job cuts are part of the Federal Reserve’s plans to control inflation, as the central bank believes a higher unemployment rate is needed to combat inflation.

As Martin pointed out, higher borrowing costs won’t hit most “junk” borrowers until they need to refinance. But borrowers who rely heavily on floating-rate products, such as leveraged loans, could see the impact of higher borrowing costs more quickly. Many corporations rely on both junk bonds and leveraged loans, and higher rates on these products could quickly have knock-on effects for the stock market and the broader economy, Miller said.

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