The junk bond market is showing signs of stress, with credit spreads widening to levels not seen since April, especially for the riskiest CCC-rated debt. While experts describe the situation as ‘flashing yellow’ rather than ‘red,’ they advise investors to remain selective and monitor broader high-yield spreads, particularly in the BB cohort, as economic conditions and Fed policies continue to evolve. Investors are demanding higher compensation for taking on credit risk amidst rising borrowing costs and inflation concerns.
Cracks are indeed forming in the junk bond market, signaling a cautious 'yellow light' rather than an immediate 'red alert.' Investors are increasingly demanding higher compensation for holding the riskiest debt, pushing up yields and widening credit spreads. While it may not be time to abandon high-yield bonds entirely, experts are urging investors to pay close attention to emerging warning signs.
Currently, high-yield bonds are offering an attractive yield of 8.1%, a notable increase from 7.22% just a month prior. This surge reflects a broader climb in yields across the market, as investors factor in heightened inflation risks stemming from elevated energy prices and the nation's burgeoning deficit, which recently neared $2 trillion for the fiscal year ending September 30.
The high-yield market is also exhibiting signs of credit stress, with spreads recently expanding to levels not witnessed since April, according to data from the Federal Reserve Bank of St. Louis. Credit spreads, which measure the yield difference between corporate bonds and U.S. Treasurys of similar maturities, indicate that wider spreads mean investors require greater returns for assuming corporate debt, viewing it as a riskier proposition.
Presently, spreads in the overall high-yield market stand at 315 basis points (bps), higher than a year ago but still below the 346 bps peak observed in March. One basis point equals one-hundredth of a percent (0.01%). The market comprises bonds rated BB+ by S&P and Fitch, and Ba1 and lower by Moody's. The most significant movement has been concentrated in the lowest-rated cohort, CCC and below, where spreads have dramatically climbed to approximately 1,250 bps over the past year.
'Flashing Yellow'
Michael Arone, chief investment strategist at State Street Investment Management, characterizes the high-yield market as "flashing yellow" but stresses it is "far from red." He notes that it's natural for investors to demand more compensation for increased credit risk amidst rising borrowing costs.
With the 10-year Treasury yield recently hitting its highest level since 2002, yields are elevated across the board. Arone posits the crucial question: "The bigger question is whether this is simply a repricing of interest rate risk, or the beginning of a more fundamental reassessment of credit quality." He remains in a wait-and-see mode, citing ongoing earnings growth, healthy interest-coverage ratios, and a manageable uptick in default rates.
However, Arone acknowledges that the relatively low starting point for spreads by historical standards is unsettling for investors. "There's a small margin of error here, which I also think raises the anxiety level," he explained. "The compensation that investors are receiving for taking on this credit risk isn't overwhelming relative to history, and therefore subtle changes in credit spreads can be concerning."
'Logical Cracks'
Despite concerns in the lower-rated segments, the broader high-yield market remains fundamentally sound. Kelley Gerrity, a fixed income strategist at Morgan Stanley Investment Management, points out that credit quality is at a record high, with BB bonds constituting over 60% of the market—a significant increase from 38% before the global financial crisis.
"We've had higher-quality companies coming in, and with higher rates now, you also have more discipline from companies that are more indebted...just because of the higher cost of capital, so that actually is creating a bit of a healthier picture as well," Gerrity added.
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Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research, notes that the lowest tier of high yield has always been more speculative due to higher default risk, making their widening spreads unsurprising. He describes the overall movement in high-yield spreads as "orderly." "Are there cracks forming? I think the cracks are logical cracks with the lowest-rated bonds and it's too early to say that it's spreading to the broad credit market."
Gerrity further clarified that fluctuations within the CCC-rated and lower spreads have been idiosyncratic. Morgan Stanley's analysis divides this cohort into performing (spreads below 1,000 bps) and non-performing assets. The non-performing spread to worst currently stands at 2,818 bps, while the larger performing bucket registers at 461 bps. "It is isolated," she said. "I'm not necessarily sure that that will go away anytime soon, but it doesn't tell the story of overall concern and flashing caution for credit markets right now." For now, Gerrity advises selective investing within higher yield, favoring the single-B cohort for relative value opportunities.
Warning Signs
Investors should become concerned if a steep widening occurs in the broader high-yield market. However, there's currently scant evidence of stress within the BB cohort, where spreads are at 194 bps, up from 179 bps a year ago, though not in a straight line. Martin emphasizes, "We're going to be focusing our attention on what are considered some stronger businesses. If we start to see the markets demand higher spreads there also, that's what we'll be looking at to see if risks are really rising."
R.J. Gallo, chief investment officer of global fixed income at Federated Hermes, highlights that the Federal Reserve is raising rates in a robust economic environment. The central bank is addressing inflation concerns amid high fossil fuel prices (partly due to the Iran war) and stronger-than-expected growth. "With growth being good as the reason that the Fed is hiking, then you wouldn't expect high yield to blow out because growth means revenues stay up, means cash flow and profitability stays up," Gallo explained.
High yield markets typically face disaster during sharp economic downturns, when spreads truly widen. "But a recession is not the odds-on bet," Gallo concluded. "Now, talk to me in six months if the Fed keeps hiking over and over, if oil prices stay high for longer, well, then maybe we will start to wonder."
