The junk bond market is showing ‘flashing yellow’ warning signs as investors demand higher compensation for risk, particularly evident in widening spreads for the lowest-rated CCC bonds.
Despite this, experts like Michael Arone, Kelley Gerrity, and Collin Martin suggest these are ‘logical cracks’ within the speculative segments, rather than a sign of broader credit distress, citing overall strong market fundamentals.
Investors are advised to remain selective and monitor for steeper, more widespread widening in higher-quality high-yield bonds and any potential shift towards a sharp economic downturn, which would signal more significant trouble.
The junk bond market is beginning to show signs of strain, prompting investors to demand greater compensation for holding some of the riskiest debt instruments. While it's not yet time to abandon high-yield bonds, market participants should closely monitor emerging warning signs.
High-yield bonds are currently offering an 8.1% yield, a notable increase from 7.22% just a month prior. This surge reflects a broader rise in yields across the curve, as investors factor in persistent inflation—driven partly by high energy prices and other economic pressures—and growing concerns over the national deficit, which neared $2 trillion in the last fiscal year.
Stress within the high-yield market is also evident on the credit side, with spreads widening to levels not seen since April, according to data from the Federal Reserve Bank of St. Louis. Credit spreads, representing the yield difference between corporate bonds and comparable Treasurys, indicate that investors are requiring higher returns for taking on corporate debt, perceiving it as riskier.
Overall high-yield market spreads now stand at 315 basis points (bps), higher than a year ago, though still below the 346 bps recorded in March. One basis point equals 0.01%.
The high-yield market encompasses bonds rated BB+ by S&P and Fitch, and Ba1 and lower by Moody's. The most significant movement in spreads has been observed in the lowest-rated segment, CCC and below, which have dramatically climbed to approximately 1,250 bps over the past year.
'Flashing yellow'
Michael Arone, chief investment strategist at State Street Investment Management, describes the current high-yield market as "flashing yellow," but reassures it is "far from red." He explains that it's natural for investors to demand increased compensation for credit risk as borrowing costs escalate across the board.
The 10-year Treasury yield, for instance, recently hit its highest level since 2002. Arone poses a critical 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 maintains a cautious 'wait-and-see' stance, noting that corporate earnings continue to grow, interest-coverage ratios remain robust, and while default rates have slightly increased, they aren't yet cause for significant alarm. However, Arone acknowledges that historically low starting points for spreads heighten anxiety. "There's a small margin of error here, which I also think raises the anxiety level," he stated, highlighting that the current compensation for credit risk isn't overwhelming compared to historical norms, making even subtle changes concerning.
'Logical cracks'
Despite the worries in the lower-rated market segments, the overall 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. BB bonds now constitute over 60% of the market, a significant jump 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 ... so that actually is creating a bit of a healthier picture as well," Gerrity added.
Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research, echoes this sentiment. He notes that the lowest tier of high yield has always been more speculative and prone to higher default risks, making the recent widening of spreads in this segment "logical cracks." He sees the overall move in high-yield spreads as "orderly" and believes it's premature to declare a widespread problem in the broader credit market.
Gerrity further clarified that fluctuations within the CCC-rated and lower spreads are largely "idiosyncratic." Morgan Stanley has segmented the lowest cohort into 'performing' assets (spreads up to 1,000 bps) and 'non-performing' assets (above 1,000 bps). The non-performing spread to worst is 2,818 bps, while the performing bucket, which represents the majority of the CCC market, is at 461 bps. This isolation suggests the issue is not systemic. "It is isolated," Gerrity 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 investors to remain selective within high yield, favoring "the best relative value opportunities," particularly within the single-B cohort.
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Warning signs
Investors should become seriously concerned if there's a steep and widespread widening across the broader high-yield market. However, there's currently little evidence of significant stress in the higher-quality BB cohort, where spreads are at 194 bps, up from 179 bps a year ago, but without a linear increase.
"We're going to be focusing our attention on what are considered some stronger businesses," Martin stated. "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, emphasizes the context of the Federal Reserve's rate hikes: they are occurring within a strong economic environment. The central bank is primarily battling inflation, exacerbated by high fossil fuel prices tied to geopolitical events like the Iran war, while economic growth has surpassed expectations.
"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, which leads to substantial spread widening. "But a recession is not the odds-on bet. 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."
