Junk Bonds Give the Optimists a Reason for Being

(Bloomberg Opinion) -- Here's something for the glass-half-full crowd. At a time when concerns are mounting over the possibility of a global trade war, emerging markets are coming under severe stress and the global synchronized economic recovery that underpinned markets in 2017 has fallen apart, junk bonds are proving to be an oasis of calm.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index was up 0.65 percent this month through Wednesday, the most among 19 major fixed-income indexes and topping even the ultimate haven asset: U.S. Treasuries. At 3.58 percentage points, the extra yield investors demand to own below investment-grade corporate bonds instead of Treasuries is about unchanged for the month and down from 2.75 percentage points at the end of last year. Credit markets are the financial system's early warning system, in that they are typically the first to show signs of stress when things are falling apart. The fact that the riskiest types of credit are relatively sanguine should be a sign that financial markets, although wobbling at present, are probably more resilient than many realize.

Of course, there's no shortage of pessimists who say junk bonds are a clear sign of complacency. Their reasoning makes a lot of sense given that the Federal Reserve has started to reverse its quantitative easing program, leverage levels are back to their pre-crisis levels and the covenant quality of corporate debt — think borrower protections — is the weakest on record. But the junk bond market has a lot going for it, not the least of which is it’s getting smaller.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index has 1,819 members, down from a peak of 2,274 in March 2015. High-yield offerings for June, at close to $10 billion, are about 40 percent of the three-year average, according to Bloomberg Intelligence. That's the lowest amount of issuance for the month since 2002. And while leverage levels for all types of corporate borrowers have risen, S&P Global Ratings noted in a report this week that the U.S. nonfinancial corporate borrowers it rates had $2.1 trillion in cash holdings in 2017, a 9 percent increase from $1.9 trillion in 2016 and more than double the amount in 2009.

The global stock market is heading into the last trading day of June with almost no shot of generating a positive return for either the month, quarter or first half. In late trading Thursday, the MSCI All-Country World Index was down 1.35 percent for June, 0.78 percent for the quarter and 2.17 percent for the year. That's the worst first-half performance since 2008, when it fell 12.1 percent. Yes, trade war and emerging-market jitters have a lot to do with the poor performance, but don't discount the fact that major central banks are no longer supporting the markets like they once did. The collective balance-sheet assets of the Fed, European Central Bank, Bank of Japan and Bank of England, which grew steadily to 37.2 percent of their total GDP at the end of 2017 from less than 20 percent in 2011, are unchanged as a percentage of GDP this year, data compiled by Bloomberg show. But like with junk bonds, there are reasons to be optimistic, at least when it comes to the all-important U.S. equities market. A Strategas Research Partners survey of about 500 institutional investors found that 70 percent expect the S&P 500 Index to stay above its low of 2,581 reached on Feb. 8. That’s a turnaround from four months ago, when the majority said the worst had yet to come, according to Bloomberg News' Lu Wang. The S&P 500 closed at 2,716.31 on Thursday.

Have pity on your friendly neighborhood commodities trader. The Bloomberg Commodity Index was down 4.33 percent for the month in late trading Thursday, its worst performance since July 2016. Outside of oil and natural gas, the screens in front of traders are a sea of red, as both precious and base metals have tumbled along with agriculture products in response to the growing tensions between the U.S. and its major trading partners. Some of the worst hit commodities include aluminum, copper, soybeans, corn and wheat. Soybean prices are down 15.4 percent this month, shipments of U.S. soybeans are being redirected away from China, which has threatened to impose import tariffs early next month, according to Bloomberg News' Megan Durisin. China, which is the largest export market for U.S. soybeans, plans to impose a 25 percent import tariff on American farm products including soy beginning July 6 in retaliation against similar U.S. measures targeting Chinese goods. The U.S. Department of Agriculture said Thursday in a report that in the week ended June 21, 63,000 metric tons of soybeans for delivery in the marketing year through August were switched to Bangladesh from China. Another 60,000 tons were switched to Iran.

It was Indonesia's turn to get bludgeoned by emerging-market investors Thursday. The rupiah fell 1.47 percent to its weakest level since 2015. The benchmark Jakarta Stock Price Index tumbled 2.08 percent to its lowest since last June. Yields on the nation's five-year bonds rose to 7.66 percent. The sell-off came one day before the nation's central bank was due to announce a monetary policy decision. Investors are questioning how much more Governor Perry Warjiyo needs to do to fend off outflows in Indonesia, which has become a key market in Asia in recent years, according to Bloomberg News's Ruth Carson and Kintan Andanari. Economists predict Warjiyo and his policy board will raise interest rates for a third time in six weeks on Friday, as Indonesia gets caught in an emerging-market rout. Benefits from the two earlier rate hikes and intervention in the currency and bond markets have eroded as trade tensions between the U.S. and China sap appetite for riskier assets. A number of central banks in emerging markets have been forced to raise rates to defend weakness in their currencies in recent weeks. Warjiyo complained earlier this month that the Fed was considering only domestic U.S. objectives in setting policy, rather than the impact of its measures on foreign economies.

Bank of England Chief Economist Andy Haldane said Thursday that a steady pickup in wage growth and cost pressures show the U.K. economy is ready for a rate increase. Currency traders don't agree. They pushed the Bloomberg Pound Index down to its lowest since November Thursday. If traders really thought the U.K. economy was strong enough to warrant a rate increase, they would be driving sterling higher, not lower. Haldane, who shocked investors this month by voting for a rate increase, said he’s seeing developments that will “add impetus to cost and inflationary pressures,” according to Bloomberg News's Jill Ward and Lucy Meakin. Among them is the lifting of a pay cap for public workers that he said will have knock-on effects elsewhere because of the tightness in the labor market. Haldane also noted that workers remaining in their current jobs are starting to see a pickup in pay — a “significant development” since wage pressures had been largely confined to those moving between jobs. Here's the problem with that line of thinking: Despite low unemployment levels, major economies in recent years have struggled to boost wages. And when wages do rise, they don't necessarily translate into faster inflation.

Friday marks the last trading day before a very important Presidential election in Mexico on Sunday that may have repercussions for global financial markets come Monday. The peso, one of the most widely traded currencies in emerging markets, weakened as much as 14 percent since mid-April, in part on the prospect that populist candidate Andres Manuel Lopez Obrador will win. Lopez Obrador, the leftist candidate for the Morena party who’s pledged to put an end to corruption and poverty, has offered up some very radical views, such as nationalizing Mexico's banking industry. At this point, what investors need to prepare for is not so much a Lopez Obrador victory, but rather how wide his margin of victory will be as well as the results of Mexico's congressional elections, according to Wells Fargo & Co. currency strategist Erik Nelson. In a report Thursday, Nelson wrote that if Lopez Obrador's Morena party captures a majority in both houses of Congress, investors should brace for "knee-jerk peso weakness" as well as longer-term pressure on the currency. But if the party is unable to secure a majority in both houses of Congress or "there are otherwise meaningful checks" on Lopez Obrador's "ability to achieve his policy goals, we see room for an immediate peso recovery," Nelson wrote.

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