January 23, 2022
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Column: Unwanted bond jolt marks streak in strangely peaceful year: Mike Dolan

By on December 3, 2021 0

LONDON, December 3 (Reuters) – If the broader financial volatility is finally unblocked, the most fortunate assets could wake up from their slumber.

For most of the 20 months since the pandemic, financial assets have been bolstered by waves of government and central bank interventions designed to protect workers and businesses as authorities halt economic activity to remove the virus.

Nowhere has this been clearer than in corporate bonds – especially the riskier speculative part of this so-called junk bond market, where many of the companies most affected by the lockdowns are raising liquidity.

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But a double whammy from the prospect of central bank normalization alongside the expiration of government support, as well as another wave of new travel and social restrictions from the new omicron variant, rocked investors over the course of the year. from last week.

While US high-yield bond funds had the biggest outflows in eight months in November, according to data from Refinitiv Lipper, junk bond yield premiums have exploded this week to their highest level since the COVID hit. -19 last year. At -1.0%, average monthly returns have also been the most negative since then. Read more

The emergence of Omicron and hawkish central banks did not favor European junk bonds either, as aggregate high yield indices saw debt spreads against regional benchmarks reach their highest level of the year. .

If the almost worrying calm experienced on these assets is now disrupted and is catching up with rates, currencies and now the already more agitated equity markets, a very bumpy year is ahead.

Gregory Venizelos of Axa Investment Managers talks about the “bifurcation” this year between increasing interest rate volatility, government bond and currency markets, and the relatively reckless stock and credit markets.

So much so that junk US dollar bonds – adjusted for volatility – actually outperformed the S & P500 over 12 months – in the longest period of calm for high yield spreads since before the global financial crisis of 2007 / 2008, he added.

At certain levels, this low spread volatility and “straight line” yield carry could easily extend into 2022.

High yield bonds are less subject to interest rate risk, or duration, than investment grade credit – which has had a more stressful 2021. Profit growth is also expected to remain strong in the first half of the year and thus flatten current spreads.

But with equity volatility now starting to match rates and currency movements through the end of the year, and credit spread tremors also appearing over the past week, the temptation will be to cut and cut. to flee.

Raphaël Gallardo of French asset manager Carmignac sees signs of “exhaustion” in high yield markets despite their attractiveness as one of the few areas to escape deeply negative real returns as inflation rises and prices rise. nominal rates remain capped.

“There is cause for concern because if you look at short-term yields and adjust forward inflation, the real yields here are also close to zero,” Gallardo said.

“Investors can therefore engage in high levels of risk for very low expected levels of return,” he added. “The price discovery mechanism is not working as it is, the level of default rates expected in the future is probably underestimated.”

Total Return on the high and low grade US corporate debt indices over 2 years
U.S. credit spreads on A-rated credits versus BBB

‘SHOULD I STAY OR SHOULD I GO?’

The extent to which junk’s low default rates have been flattered by official support and what happens to so-called ‘zombie’ companies when that is canceled has been one of the pandemic’s biggest financial issues.

While fewer central bank largesse is expected to affect investment quality more than unwanted credits, the combination of this wave and new waves and variants of COVID-19 could disrupt both.

But despite the warnings about high-quality companies, many see a case for sticking with junk food a bit longer.

The picture of pandemic debt was complicated. For many larger and safer businesses, the rush to finance last year saw cash net debt barely budge as much of the cash inventory lay idle as profits rebounded, news reports. Debt sales were less needed this year and debt service costs remained low. .

The image was perhaps less benign for unwanted credits, but still remarkable.

Axa’s Venizelos points out that the global high-yield debt stock has grown by almost a third since 2019, but global coupon payments have only increased by about half that amount.

Additionally, earnings-focused balance sheet repair means that net credit scores have turned positive for the first time since the eruption last year, and “rising stars” migrating to higher-quality indexes are starting to fall. outnumber the “fallen angels” in the other direction.

With defaults linked to peaking last year at 9% in the United States and 5% in Europe, the default rate forecast from rating firm Moodys of just over 2% for the coming years are less than what today’s narrow spreads would imply.

Bank of America’s global lending outlook for 2022 projects another dynamic 4-5% total return on US junk bonds for the year ahead, preferring the reopening of sectors like travel, real estate, financials and more. games in the names of telecommunications, media, pharmacy or packaging.

Answering his own question “Should I stay or should I go?” », She opts for the first one.

While rate volatility or Chinese credit concerns could worsen further, the rest of the junk picture still looks positive. “Overall, this creates a still benign backdrop for credit losses: good news for high yield credit and especially good news for leveraged loans.

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Lipper chart on US high yield bond flows
Table of BofA on “Rising Stars” against “Fallen Angels”

by Mike Dolan, Twitter: @reutersMikeD Additional reports and graphics by Sujata Rao, Karen Pierog and Patturaja Murugaboopathy Editing by Mark Potter

Our Standards: Thomson Reuters Trust Principles.