Analysis | FOMO on Junk Bonds Clashes With Recession Fear

Corporate debt has a front-row seat for the showdown between the competing inflation and recession narratives dominating financial markets. The Federal Reserve’s efforts to lift interest rates and rein in the worst inflation in 40 years are intended to curb prices pressures, of course, but they may well topple growth in the process. The forces of growth and prices have strong but sometimes divergent impacts on corporate fixed income.

Consider that the yield on corporate bonds is essentially the risk-free government interest rate plus the premium — or spread — that the market demands to bear a company’s default risk. The first half of 2022 was largely about rising rates, but further signs of a recession could send that move in reverse. On the other hand, credit spreads have a real risk of widening if the economy goes south. It’s possible that one of the two forces will prevail, or they may just cancel each other out.

For now, that has all translated into one of the highest junk yields in the post-crisis era. As my Bloomberg Intelligence colleague Noel Hebert tells it, “losing money is hard to do” when high-yield corporate bonds are at these levels, provided you’re a longer-term investor in the broad index and not wagering on individual companies. That’s just basic bond math, not an attempt to pick the market bottom. He laid out three scenarios of how this could play out:

• Stagflation: Spreads widen from the current 539 basis points toward 1,000 basis points as they have in previous recessions, and Treasury yields increase again as the Fed has to keep raising interest rates. All told, high-yield bonds lose an additional 12% to 15%.

• Traditional recession: The pertinent part of the Treasury curve (five- to seven-year notes) rallies, bringing government yields below 2%, but high-yield spreads widen to, say, 800 basis points. It’s mostly a wash and returns are plus or minus 3%.

• Continued expansion: The Treasury yield curve may rise a bit more, but the spread compression will more than offset the damage, producing a total return of perhaps 10% to 12%

The nightmarish stagflation scenario would be such a historic anomaly that investors can probably underweight it (20% odds versus 40% for the other two). That suggests a weighted average outcome that’s marginally positive. In that case, the math says it pays to play the game.

The setup for investors is far from terrible. Company finances are still reasonably healthy, and for now, a Bloomberg barometer that gauges the number and impact of bankruptcies — considering the dollar amounts of the involved liabilities — just touched its series low. Many corporate borrowers took advantage of low rates during the pandemic to bring forward their financing needs, and the market isn’t facing a serious wall of maturities coming due until 2024. Fitch Ratings projects the US high-yield default rate will finish 2022 at 1%, up but not drastically from the 0.3% trailing 12-month rate it hit earlier this year, the lowest on record dating to 2001.

There’s also a prevailing sentiment among economists that any economic contraction would be on the mild side. As for the index, the average credit quality has improved slightly over the past decade.

Clearly, everything comes down to a particular view of the economy and inflation. The latest job market data published Friday suggested that neither the economy nor inflation are particularly close to crashing, which may suggest spread compression in the near term but marginally higher interest rates. But the fact that the job market is strong today doesn’t mean the scenario can’t change quickly as the Fed tightens financial conditions further, and there’s plenty of room for more corporate bond pain ahead. 

Recessions are never easy on companies or creditors, and there could be trouble lurking in the more opaque corners of the market, including the leveraged-loan and private-credit markets that have ballooned since the financial crisis. But as for high-yield bonds, investors need to carefully weigh their stagflationary nightmares against the equally real risk of missing out on some of the richest yields in recent history.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company’s Miami bureau chief. He is a CFA charterholder.

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