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Junkiest Junk Bonds Flash a Warning Sign for the Economy

Junkiest Junk Bonds Flash a Warning Sign for the Economy

The riskiest subset of U.S. junk bonds has lost its allure. 

The extra compensation investors are demanding to hold America’s most-speculative debt has risen around 50 basis points this month on concern economic growth is slowing and the chance of a recession is increasing.

Spreads on CCC-rated debt -- bonds most at risk for a default should the economy falter -- have widened 125 basis points this year, compared to 57 basis points for BB rated debt and 69 basis points on average for all junk bonds, according to data compiled by Bloomberg..

“We are steering away from the most egregious parts of the market in terms of credit risk,” said Jack Parker, research analyst at Brandywine Global Investment Management. “Investors would be smart to avoid CCC risk, especially the highly levered LBO deals where interest coverage is low and covenants are loose, leaving little room for error should they experience a fundamental slowdown in the business.”

While all credit markets are being hurt by accelerating inflation and the effects of a war in Ukraine, higher yielding CCC rated debt until recently held up well compared to higher grade bonds that are more sensitive to rising rates. But the sector, defined by companies with big debt levels compared to earnings or low free cash flow -- is a barometer for businesses vulnerable to economic shocks.

Junkiest Junk Bonds Flash a Warning Sign for the Economy

And Wall Street sees shocks on the way. 

Goldman Sachs Group Inc. said this week that the odds of a recession in the next two years have climbed to 35%. Federal Reserve Bank of St. Louis President James Bullard said on Monday that the central bank needs to move quickly to raise rates to around 3.5% this year with multiple half-point hikes and that an increase of 75 basis points shouldn’t be off the table. Yields on U.S. junk debt rose to 6.57%, a near 21-month high.

Junk deals in the primary market are showing signs of trouble as well. A group of banks led by JPMorgan Chase and Co. and Citigroup Inc. last week struggled to offload over $2 billion of junk debt to help finance the buyout of Oldcastle BuildingEnvelope Inc. The company’s unsecured bond sale -- rated in the CCC tier -- priced at a steep discount.  

To be sure, the U.S. high-yield default rate is expected to stay at around 1% through this year, even after March saw the most defaults since July 2020, according to a report by Fitch Ratings. And CCC spreads, while high now, are still low by historical standards. Those risk premiums blew out to 19 percentage points in March 2020. 

Still, fixed-income investors are looking for bonds that can withstand an economic downturn. Some money managers in Europe, including Fidelity International, Three Bridge Capital, Deutsche Bank AG and Premier Miton Investors, are taking the view that investment-grade is the best place to be. 

Since a market-wide rally in March as the initial market shock of the war in Ukraine faded, European high-yield spreads have widened four times as much as investment-grade spreads, according to data compiled by Bloomberg. 

“The high level of current uncertainty around the war in Europe, slowing growth, high inflation and tightening financial conditions mean we prefer to be positioned defensively in credit,” said Becky Qin, portfolio manager and senior manager selection analyst at Fidelity, commenting on the euro and dollar markets.

The firm’s multi asset team, which manages assets of $51 billion, switched to an overweight position in investment-grade debt and underweight high-yield last month in a reversal of its stance from the start of the year. 

Elsewhere in credit markets:

Americas

JPMorgan Chase & Co., Bank of America Corp. and Bank of New York Mellon Corp. are tapping the the U.S. investment-grade bond market Tuesday, the latest Wall Street banks to follow earnings reports with debt sales.

  • U.S. borrowers that issued leveraged loans tied to the London interbank offered rate prior to the start of the year could switch to the Secured Overnight Financing Rate sooner than expected should the gap between the two benchmarks continue to widen
  • U.S. junk bonds declined as yields edged higher and the broader index posted losses for the second straight session, with the markets continuing to focus on the prospect of faster policy tightening by the Federal Reserve amid forecasts of the likelihood of a recession
  • For deal updates, click here for the New Issue Monitor
  • For more, click here for the Credit Daybook Americas

EMEA

Three issuers including Royal Bank of Canada and BPCE priced at least 2.75 billion-euros equivalent ($2.97 billion) on Tuesday. 

  • Russia’s big-business lobby pitched a plan for default-proofing bond payments as some of the nation’s largest corporations struggle to get funds to investors
  • Eurasian Development Bank launches tender offer for its $500m 4.767% notes due in September, offering to buy them back at a minimum price of 70% of face value and a maximum of 80%

Asia

Chinese junk dollar bonds dropped 1-2 cents on the dollar Tuesday morning, according to credit traders, after property agency operator E-House (China) Enterprise Holdings Ltd. became the latest default in the country’s indebted real-estate sector.

  • India’s JSW Group, which runs emissions-heavy businesses including steel, cement and energy, plans to switch a majority of its bonds to green instruments as the industrial giant seeks access to longer-term borrowings
  • Sri Lanka’s dollar bond due in July extended gains after the nation’s opposition leader suggested they will back austerity measures to achieve economic stability

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