Credit’s strong run so far stumbles for first time this year


FILE PHOTO: A view shows a bronze seal beside a door at the U.S. Treasury building in Washington, U.S., January 20, 2023. REUTERS/Kevin Lamarque/File Photo

NEW YORK: Global corporate bond spreads are on track to turn in their first month of weakening since late last year, reigniting the debate about the relative value of credit versus other fixed-income classes heading into the second half of 2024.

Spreads on corporate bonds including junk and investment-grade notes have widened by about 10 basis points so far in June, from around the lowest levels seen in three years, a Bloomberg index shows.

Meanwhile, yield premiums on those notes as well as US high-grade bonds are rising from levels touched in May which have only been seen for less than 1% of the period since the 2008 global financial crisis, the data shows.

While heavy spread widening would make credit less attractive compared with Treasuries, Goldman Sachs Group Inc strategists led by Lotfi Karoui don’t see that happening.

The bank forecasts US high-grade spreads ending 2024 at 90 basis points and junk spreads at 291, compared with current Bloomberg index levels of 94 basis points and 314 basis points, respectively.

“We’re in this holding pattern of the macroeconomic backdrop, which is not too hot, not too cold,” said Neeraj Seth, chief investment officer and head of Asia-Pacific fundamental fixed income at BlackRock Inc in Singapore.

That’s normally a “good environment” for credit, and while spreads may widen at different junctures, there’s still potential for them to tighten back over a six to nine-month outlook, he said.

Investors aren’t getting paid a lot for credit risk, according to abrdn investment director Luke Hickmore. However, he still sees an argument for holding corporate debt as spreads could remain around current levels for several more years, similar to the period between 2004 and 2006 when interest rates stayed high.

“Fundamentals are pretty good at the moment” after many companies cut debt, he pointed out. “With de-leveraging, a fairly stable economic outlook and the high interest-rate profile, you may as well get the extra carry.”

A decline in US Treasury yields this month on renewed bets that the US Federal Reserve (Fed) will cut interest rates at least once this year is partly responsible for credit spreads widening, as corporate bonds usually take time to catch up to moves in more liquid government debt.

“Historically spreads struggle to tighten when yields are declining, until they stabilise again,” JPMorgan Chase & Co strategists Eric Beinstein and Nathaniel Rosenbaum wrote in a note this month.

It’s uncertain whether it will cause some investors to step back, as was observed earlier in the month, they added.

For some, the problem with corporate credit has more to do with its meager yield pick-up relative to its risks than with any clear signs of weakness in economies or problems on corporate balance sheets.

Noah Wise, a portfolio manager at Allspring Global Investments, says he’s been taking advantage of the recent rally in high-yield bonds to lower his exposure to the debt.

He added that he prefers US agency mortgages that have AA type ratings with spreads in the 50s.

“There is a historically narrow amount of incremental spread for credit risk at this point, so valuations aren’t attractive,” he pointed out. “We’re relatively lightly positioned.”

So far this year, corporate bonds have outperformed US Treasuries. That’s expected to continue, with Goldman strategists seeing both high-grade and high-yield bonds in US dollars and euros outperforming government bonds this year.

European junk bonds may deliver 5% in excess returns in 2024, while their US equivalents may generate 3.7%, the bank said in a June report, while European and US high-grade securities may deliver 2.7% and 1.6% respectively on the same measure.

Metrics at US high-yield debt issuers have been mixed. Firms showed broad-based deterioration in the first quarter with profit margins dropping to a three-year low, though leverage was comfortably below the long-term average, JPMorgan strategists including Nelson Jantzen wrote in a June 12 note.

“In this type of environment where spreads are very tight, the front end of the curve, shorter-dated bonds, is where I’ll be looking for carry,” said Marvin Kwong, a fixed-income portfolio manager at M&G Investments who likes Asian bank capital securities.

“In the long end of the curve, given where spreads are, I would rather opportunistically position in Treasuries or futures given the volatility” to take advantage of any move lower in yields, he added.

Kwong expects the Fed to cut one or two times this year and three to four times next year, with economies broadly holding up.

Gabriele Foa, a portfolio manager at Algebris Investments, warns that “the fundamental picture is deteriorating a little bit and credit spreads are at absolute tights”.

“This is already an alarm bell,” he said. “We have a few longs but overall we have the most cautious positioning we’ve had in credit in the past couple of years.”

For Pauline Chrystal, a fund manager at Kapstream Capital in Sydney, the tight valuations on US dollar-denominated corporate bonds are also a concern. She prefers Australian credits where valuations are less stretched.

“That credit spreads could tighten another 20 or 30 basis points is something that I just find really hard to believe,” she said. “But if momentum is very strong and every one of your peers is continuously investing in credit, you can’t just sit in cash.” — Bloomberg

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