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.
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.