The worst is yet to come for US credit markets, investors say in survey

Bloomberg: The ugliest year ever for US corporate-bond investors is expected to get uglier — and they only have the Federal Reserve to blame.

With the central bank raising interest rates at the fastest pace in decades, nearly three quarters of those who responded to the MLIV Pulse survey said that tighter monetary policy is the biggest risk facing the corporate-debt market. Just 27% were more concerned that corporate bankruptcies will pile up over the next six months.

The results underscore the bittersweet outlook for fixed-income investors that were hit during the first half of the year with the deepest losses since at least the early 1970s. The survey included responses from 707 investment professionals and individual investors.

On one hand, they don’t think the troubled run is over, with more than three quarters anticipating that yields this year will widen to new peaks over Treasuries. But, at the same time, a majority expects the downside to be relatively limited. They predict that spread — a key gauge of the extra compensation demanded for the perceived risk — will hold well below the levels seen during the March 2020 Covid crash or the recession set off by the housing market downturn.

“There is definitely much more downside, or risk, to widening from where we are right now,” said Kurt Daum, senior portfolio manager at USAA Investments, a Victory Capital franchise.

Yields on corporate bonds have edged steadily higher over Treasuries during the waves of selling that raced through fixed-income markets this year. That spread on investment-grade corporate debt reached as much as 160 basis points in July, according to Bloomberg’s index, before pulling back slightly.

But the relatively muted spread increases anticipated ahead show investors expect the corporate-finance market to avoid the kind of stress that followed the 2007-2009 recession, when investment-grade yields surged to more than 600 basis points above Treasuries. In March 2020, that gap hit nearly 400 basis points, prompting the Fed to step in to ensure that a lack of available credit didn’t deal another hit to the economy.

The outlook likely reflects the strong position many companies are in after profits surged on the back of pandemic-related stimulus and two years of rock-bottom interest rates. Despite speculation that the US is veering toward a recession, on Friday the Labor Department reported that hiring unexpectedly surged in July by the most in five months, underscoring that the economy remains strong despite the Fed’s aggressive monetary policy tightening.

As a result, some 86% of survey respondents said that companies are better positioned to weather a recession than they were in 2008. That’s in part because many businesses refinanced their debts after the Fed slashed rates in 2020.

Still, the strong balance sheets aren’t expected to be enough to prevent further losses, particularly for junk bonds, which would be more sensitive to an economic slowdown. Yields haven’t likely peaked yet and may rise beyond the nearly 9% high in late June, respondents say.

Such risk means that some bonds, like those in CCC ratings tier, among lowest rung of junk status, are not as attractive as more highly rated securities, according to John McClain, high-yield portfolio manager at Brandywine Global Investment Management.

“We would urge extreme caution in the CCC segment,” McClain said. “Investors should take some duration and some credit risk, but too much of either is a recipe for disaster.”

Nearly a half of survey participants said they expect stocks to outperform corporate debt over the next six months. A little over a third prefer investment-grade debt, more than twice as many as those who expect better gains from junk bonds. That would mark a break with the pattern so far this year, when junk bonds outperformed as shorter maturities and high-coupon payments provided a buffer from the price drops caused by the Fed’s rate hikes.

USAA’s Daum said that shift may reflect that many junk bonds are rated on the higher spectrum of the scale than during previous periods.

“The high-yield market has become much more high quality — with more interest-rate sensitive BBs — in the last three to four years,” he said. “Because of this, the rate impact is going to be more pronounced in high yield than it has been historically.”

The increase in borrowing costs and the uncertain economic outlook, meanwhile, are set to keep merger and acquisition activity low into year-end, according to most participants. Buyouts involving private equity firms have dropped sharply after a record 2021 as bankers’ underwriting appetite for debt faltered amid losses.

The world’s top investment banks recently disclosed a nearly $2 billion hit from struggling leveraged buyout financings.

The survey also showed that over 60% of respondents expect Chinese offshore bond defaults won’t decline in 2023 from this year. Such debt failures have mounted to a record amid a broader debt crisis in the nation’s property market. Coming weeks may bring more pain.

“China’s offshore trailing 12-month default rate may rise further to 6.5% from the current 6.2% if two of the 589 issuers miss an interest or principal payment in August, in our scenario,” Bloomberg Intelligence wrote in a report.

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