Junk bonds: Junk bonds: An unlikely haven for investors wary of rate hikes


LONDON: With the possibility of a market sell-off due to inflation, many bond investors are retreating into the unlikely safe haven of bad bonds, an industry generally considered to be one of the riskiest.

Corporate bonds rated below BBB-minus are considered less secure, hence the term “junk” or “high yield” market. They offer better yields to compensate for the higher default rate compared to investment grade companies.

Yet, with investors believing that the main risk to bond markets right now is tightening monetary policy, these higher yields are seen as a buffer rather than a warning signal.

With the United States recently recording higher than expected inflation, investors fear the Federal Reserve will start to “cut”, or relax, its monetary impressions.

“Investment grade fixed rate bonds are very expensive and very tight and would be extremely sensitive to any concerns from the markets about higher rates,” said Cosimo Marasciulo, head of absolute investment returns at Amundi, the largest manager in the world. ‘active in Europe. “There is absolutely no protection against spreads,” he added, referring to bond yield premiums over government debt.

Indeed, Markit’s iBoxx index suite shows the tightest high-quality US and European spreads ever against benchmarks of government debt. They have tightened aggressively over the past 10 months after the Fed added them to its asset purchase program and the European Central Bank stepped up its purchases.

Investment grade US bonds are currently paying a yield premium of 103 basis points over Treasuries, a record high, according to Markit’s iBoxx index.

Junk Bond funds, meanwhile, have benefited from nine straight weeks of investment inflows, according to the EPFR fund tracker, which also highlights six straight weeks of flows to exchange-traded funds (ETFs). dedicated.

The sector has generated returns of more than 2% since the start of the year, while holders of investment-grade debt have suffered a loss of 3.6%, according to the ICE BofA indices.

DURATION DIFFERENCE

Eight years ago, the boss of the Fed, Ben Bernanke, had suggested that it was necessary to reduce, or decrease, the purchases of assets instituted for the first time in the aftermath of the financial crisis of 2008. The wild sale which followed was nicknamed the “taper tantrum”.

Now, US President Joe Biden’s $ 1.9 trillion spending plan and recent robust economic data has led markets to bet that the Fed will start cutting back on asset purchases from early 2022.

The 2013 tantrum saw junk bonds suffer more than their highly rated peers. This time around, the ax may fall more heavily on investment grade debt for two reasons: tighter spreads and longer duration.

Duration, which is a function of the time it takes creditors to recover their investment, is considered a measure of the sensitivity of a bond’s price to interest rate risk.

Years of easy credit allowed companies to issue more long-term debt, bringing the average duration of U.S. investment grade bonds to a near record 7.7 years, down from 6.6 years in 2013.

The average duration of junk debt is 3.34 years, according to the Markit iBoxx indices.

“The big cloud hanging over liquid markets is the rate risk induced by inflation. We are very focused on rate volatility and its impact on bond markets, so we are underweight longer term and fixed rate investments, ”said Joseph Moroney, co-head of global corporate credit at Weights. heavy private equity

.

Instead, Apollo focuses on floating rate securities such as leveraged loans, where yields rise when rates rise. Moroney also descends the risk curve towards single-B debt bonds, where average returns of 4.6% exceed the overall tip index.

Junk bonds are of course risky; The rating agency S&P Global predicts default rates of 7% by the end of the year, against 6.6% in December 2020. On the other hand, the defaults of investment grade firms are close to zero; even securities rated BBB, the lowest level of investment, have a historic default rate of 0.3%.

Harry Richards, a fund manager for UK fund manager Jupiter touts a “dumbbell” approach – some holdings of government bonds “while closely exploring the riskier parts of the market, which still have carry potential and decent increase ”.

He believes that good quality debt fully evaluated the positive news and therefore “took chips off the table.”


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