Macro: Sandcastle economics
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Rotation to quality will expose junk bonds’ fragilities.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: As the macroeconomic picture becomes more hostile, with interest rates remaining at the highest level in over twenty years and the economy decelerating markedly, investors will soon need to shift their focus from inflation to quality. Junk corporate bonds, which have provided a much-needed buffer against inflation in the past couple of years, have deteriorated noticeably compared to pre-COVID averages. In some cases, leverage has almost doubled while interest coverage has dropped sharply. With the risk-free rate at 5%, it doesn’t make sense to take additional credit or duration risk. Therefore, rotation from junk to quality will likely accelerate in the next few months, widening corporate spread significantly. Yet, investors can secure a pickup over the risk-free rate without taking excessive risk in sectors such as basic industry, energy, and capital goods, whose fundamentals have sensibly improved since pre-COVID. Although we remain defensive in terms of duration, there are selective opportunities for income seekers in the long part of the yield curve.
During the past couple of years, investors’ only hope to build a buffer against inflation was by building a junk bond portfolio. The reason is simple: lower-rated bonds have been offering a yield and coupon high enough to become an effective hedge against elevated inflation while the US economy was still buoyant. According to Bloomberg indexes, junk bonds returned 7% year to date. In contrast, investment-grade corporates returned 1% within the same time. With inflation averaging more than 4% throughout the year, high-grade assets provided a negative real total return.
As price pressures and the economy slow, investors' attention gradually shifts from inflation to quality. While junk bond yields went from 5.1% at the beginning of 2020 to 8.9% today, that 380bps move higher can mostly be attributed to rising rates. The US junk credit spread has only widened by 60bps in the same period. With interest rates more than double where they were in 2019 and the economy starting to falter, it is impossible not to expect an increase in defaults that will inevitably widen credit bond spreads.
Therefore, we expect rotation from risky assets to quality assets to begin ahead of Christmas but to be prominent during the first half of 2024. Investors will be compelled to rotate from junk to the risk-free rate now that US Treasury yields pay 5% more or less across the whole yield curve rather than sitting on deteriorating junk at 9%. That will apply pressure on the high-yield-investment-grade spread (HY-IG), now trading around 270bps, in line with pre-covid valuation. Within the current macroeconomic backdrop, the HY-IG spread will likely widen to 400bps and spike above that level in case of distress.
Banks' junk bonds distort the picture when looking at corporate bond averages. Although junk-credit spreads have indeed widened considerably during the past three years, junk corporate bonds, excluding financials, are just paying 279 basis points over their investment-grade peers, less than what junk pays over quality in the US, and more or less in line with what we have seen pre-COVID pandemic.
Euro-denominated junk financial bonds are instead paying a whooping 650bps over their high-grade peers, the highest since 2012. The divergence between financial and corporate bond spreads has been clearly triggered by the SVB crisis in March.
When zooming in on European corporate bonds, excluding financials, we note that credit fundamentals have deteriorated broadly. That's a stark difference from what we see in the US, where certain sectors both in the investment-grade and high-yield space have been deleveraging while improving interest coverage since the COVID pandemic (for more information, click here).
Deterioration in the European junk bond space has been expansive, with only the basic industry sector improving leverage and interest coverage compared to pre-COVID averages.
The good news, however, is that the wall of maturities for the euro junk bond space doesn't start until 2025, removing some refinancing risk as the ECB remains on hold. Yet, as we enter 2024 and refinancing dates approach, financial markets will likely reconsider credit risk, causing a widespread widening of credit spreads.
Only companies in capital goods, transportation, and energy have seen an improvement within the investment-grade space, while leverage has been growing astonishingly among all other sectors.
At this juncture, deterioration continues to be the most likely path for corporates in the old continent. With Europe entering a recession and the ECB remaining on hold, credit spreads will likely widen in the upcoming months. Therefore, we favor quality over risk and remain defensive.
Here is an inspirational list of investment-grade euro-denominated bonds:
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