Fearing the Fed, Credit Investors Are Buying More Junk Instead

(Bloomberg) -- U.S. company-debt investors fear the Fed more than they fear defaults.

That’s what U.S. bond and loan markets are signaling now. Safer types of debt, like Treasuries and investment-grade corporate bonds, have dropped this year. But the riskiest high-yield bonds -- rated in the CCC range-- gained 0.9 percent through Wednesday. And loans to junk-rated companies have risen even more, decoupling from bond prices that they are usually tightly correlated with.

Investors’ willingness to take on credit risk was evident in the market for new bonds and loans this week. WeWork, an office-space-leasing company with negative free cash flow rated Caa1 by Moody’s Investors Service and B+ by S&P Global Ratings, sold $702 million of bonds on Wednesday, and received orders for around three times that amount. Jagged Peak Energy, an oil and gas driller rated B by S&P, got orders for its bond sale equal to five times the amount originally offered.

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This kind of demand makes sense if money managers aren’t worried about a contracting economy for at least the near term. Rising interest rates lift companies’ borrowing costs over time, but for now tax cuts are boosting bottom lines and profit in the first quarter has been strong so far.

“We aren’t looking at an extreme default environment,” said Mona Mahajan, U.S. Investment strategist at Allianz Global Investors, which managed about $600 billion of assets as of the end of March. “It’s almost all interest-rate concerns right now.”

More Hikes

The Federal Reserve is expected to lift rates two or three more times this year. Tax cuts of around $1.5 trillion combined with $300 billion of new federal spending are boosting the U.S. Treasury’s borrowing needs, which helped push benchmark 10-year Treasury yields above 3 percent this week for the first time since December 2013.

Leveraged loans pay floating rates, so as the Fed hikes, loans will pay more. In theory they are also safer than bonds because lenders are first to be paid when a borrower goes belly up. But companies have many more loans on their books in this credit cycle compared with historical norms, so even if the debt is safer than junk bonds, it’s hardly safe, and losses are likely to be bigger than they have been historically. Demand is staying strong for loans now because they pay a floating rate, said Matt Daly, head of credit research at asset manager Conning.

Conscious Decoupling

Strong demand for floating-rate debt has helped lower the correlation between loan and junk bond prices. For the past 15 years, the correlation between the two has been around 0.85, signaling that the two typically move in the same direction, said Jonathan Sharkey, portfolio manager at Amundi Pioneer. For the last 12 months, it’s been closer to 0.55. Between 2004 and 2006, when rates were last rising, that figure fell to around 0.3, he said. Correlation figures range between -1 and 1, with 0 signaling little relationship, and -1 signaling two figures move in opposite directions.

For junk bonds, the higher coupons offered by the securities on the riskier end of the speculative-grade spectrum can help absorb losses that result from higher rates and Treasury yields, said Gene Neavin, portfolio manager at Federated Investors Inc. Lower tax rates may help lift earnings growth and encourage companies to invest more in their businesses for now.

Longer Term

The longer-term outlook worries a number of investors. Money managers from Guggenheim Partners to TCW Group Inc. and Pacific Investment Management Co. have cautioned that the next big financial downturn could start in corporate debt. Easy-money monetary policies have allowed firms to load up on borrowings, with around 37 percent of companies being classed as highly leveraged in 2017 compared with 32 percent in 2007, according to S&P Global Ratings.

"When these companies come back to refinance, that will be more difficult and that may be what sparks a recession,” said Allianz Global’s Mahajan. “But that’s not in the next 12 months."

Equity analysts expected the latest company-earnings season to be the best since 2011, but investors have found reasons to be less bullish about the future. Caterpillar Inc. said on April 24 that first-quarter results “will be the high watermark for the year.” Alphabet Inc. posted the strongest sales growth in almost four years, but its shares dropped after it announced a spending binge.

For now, there are few signs that defaults will jump soon, said Brad Rogoff, head of global credit strategy research at Barclays Capital in New York.

"Markets are identifying rate risk as the key risk," Rogoff said.

--With assistance from Gowri Gurumurthy

To contact the reporters on this story: Lisa Lee in New York at llee299@bloomberg.net, Sally Bakewell in New York at sbakewell1@bloomberg.net.

To contact the editors responsible for this story: James Crombie at jcrombie8@bloomberg.net, Dan Wilchins

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