High-yield bond compensation shrinks to levels ‘only sustainable in an economic upturn’

High-yield bond compensation shrinks to levels ‘only sustainable in an economic upturn’

Compensation that investors are getting from high-yield bonds has fallen to levels “only sustainable in an economic upturn,” according to BofA Global Research. 

High-yield bonds are a form of corporate credit also known as junk debt for their below-investment-grade ratings. They provide more yield than investment-grade bonds to compensate investors for the risk they’re taking in speculative-grade debt.

Junk-bond spreads over comparable Treasurys tightened last week, with one category standing out for falling to a post-global-financial-crisis low, BofA credit strategists said in a note Tuesday. 

Spreads on high-yield bonds with a “single-B” rating fell to 317 basis points — a post-GFC record, they said. Also within junk territory, bonds with a higher “BB” rating were a few basis points “shy of getting there,” at 189 basis points, the BofA note shows.

The U.S. economy grew in the fourth quarter at an annual rate of 3.2% in the fourth quarter, according to a revised estimate from the Bureau of Economic Analysis on Wednesday. While growth of real gross domestic product in the U.S. has slowed from a strong 4.9% pace seen in the third quarter, the economy has been resilient in the face of the Federal Reserve’s monetary tightening.

“Rate cuts keep getting pushed out further as the chorus of hawkish Fedspeak grows louder,” the BofA strategists said of market expectations for the Fed to start cutting interest rates this year.

“The market is now pricing only 3.3 cuts for 2024 after a string of Fed governors implied that rate cut talk is premature,” they said, “suggesting a Fed pivot” may arrive in the second half of the year. They said less than a month ago market consensus was close to six rate cuts in 2024.

“Despite this rates U-turn, credit market conditions remain exceptionally strong,” the strategists said.

Many investors are anticipating the Fed will begin cutting rates this year on the expectation that inflation will continue to fall toward the central bank’s 2% target. The Fed has been holding its benchmark rate steady after aggressively raising it to cool the economy and lower inflation.

The central bank began lifting rates in March 2022 from near zero and is currently holding them at a target range of 5.25% to 5.50%.

‘Hot streak’

So far in 2024, the U.S. high-yield market is “extending its hot streak with spreads tightening” to 323 basis points as of Feb. 25,  “the lowest level since early 2022,” CreditSights analysts said in a note Wednesday. They said the “all-time tight” for high-yield spreads was 241 basis points in June 2007, with the market “oblivious to the brewing storm” of the global financial crisis of 2008.

In the view of the BofA strategists, a “continued profit recovery” for companies with below-investment-grade ratings “could justify tight” high-yield spreads. 

High-yield bonds are up slightly this year, while the broader U.S. bond market is down.

Shares of the SPDR Bloomberg High Yield Bond ETF
JNK
were edging up 0.1% in early afternoon trading on Wednesday, with the exchange-traded fund posting a total return of 0.4% so far this year, according to FactSet data, at last check. 

Meanwhile, the iShares Core U.S. Aggregate Bond ETF
AGG,
which invests in U.S. investment-grade debt including Treasurys, was similarly up 0.1% in early afternoon trading on Wednesday — but had a year-to-date loss of 1.8% on a total return basis.

As for Treasury yields, the rate on the 10-year Treasury note
BX:TMUBMUSD10Y
was slipping about two basis points early afternoon on Wednesday to around 4.29%, according to FactSet data. Two-year Treasury yields
BX:TMUBMUSD02Y
were little changed at around 4.68%.

“June 2007 marked a peak” in Treasury yields, with the 10-year “notching a high of 5.30% in June as the Fed held rates steady at 5.25%, a level reached a full year prior,” the CreditSights analysts said.

Riskier corporate debt was hammered in 2008 amid the global financial crisis, while safer bonds broadly ended that year with gains.

The SPDR Bloomberg High Yield Bond ETF had a total loss of almost 25% in 2008, while the iShares Core U.S. Aggregate Bond ETF saw a total return of 7.9%, according to FactSet data. 

Read: Why high-yield bond ETFs may deliver ‘surprise’ outperformance in fixed income in 2024

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