Yield gap between risky corporate debt and investment grade sinks to 12-year low
The hunt for yield is making parts of the U.S. corporate bond market look a lot like 2007.
The highest-yielding corporate debt, also referred to sometimes as “junk”— due to the borrower’s greater chance of default — typically rewards investors comparatively more than higher-rated, investment-grade bonds.
However, investors are finding that the reward for owning junk compared against comparable investment-grade debt is compressed as investors, retreat from the roughly $13 trillion in debt that pays debtholders less than zero, in search of something more richly rewarding.
That means that investors are increasingly taking on more apparent risk to find greater coupon payments.
Currently, there are only 60 basis points, or 0.60 percentage points, that separate BBB-rated corporate bonds, those on the edge of “junk,” from the highest rung of BB-rated bonds from the high-yield category, according to Morgan Stanley Wealth Management’s global investment committee.
Morgan Stanley’s investment committee created a chart showing the spread, or amount of compensation that investors require against a so-called risk-free benchmark (like Treasurys) between BBB and BB corporate bonds has dropped to a 12-year low, representing the widest yield differential between the two classes of debt since the lead-up to the 2008-09 financial crisis.
The reason behind this yield compression?
“The swelling pool of negative-yielding debt has created yet another round of inflows for credit markets where yield-hungry investors are reaching for positive real returns,” the committee wrote in a note to clients on Monday.
“The implication for U.S. corporate credit is that the quality premium, or difference between yields on the lowest-rated tranche of investment grade debt (BBB) and the best of the high yield market (BB) is now at 12-year lows.”
Things have gotten even stranger in the European high-yield market where about 2% of the euro high-yield universe is now at negative yields in the weeks since European Central Bank President Mario Draghi hinted that more monetary stimulus for the regions was a possibility.
“What you are seeing in the U.S. you are also seeing in Europe,” said Ken Monaghan, co-director of high-yield at Amundi Pioneer, in an interview Monday. “It basically tells you that people are reaching for yield.”
Still, not all has been rosy in the $1.2 trillion U.S. high-yield market in the past few months as cash has flowed in and out of high-yield funds, analysts at Bank of America Merrill Lynch warned in a note to clients on Monday.
The team, in its most recent high-yield roundup report, tracked outflows of $7.1 billion to high-yield funds between May 26 and June 7, which resulted in about a 110 basis point widening. When another $6.6 billion flowed back into the fund in early June, spreads narrowed 70 basis points.
BAML analysts in the high-yield market summary characterized the volume of flows as “an amount that should not matter” to a market that trades $10 billion on an average day.
“The steep price of liquidity was on a full displace in recent months,” the researchers cautioned.
While the S&P 500 index SPX, -0.48% Dow Jones Industrial Average DJIA, -0.43% and Nasdaq Composite Index COMP, -0.78% last week set all-time closing highs, they each finished lower for a second straight session on Monday.
That has some looking at the potential for pain if volatility spikes anew, or if substantial, market-boosting interest-rate cuts expected from the Federal Reserve fail to materialize.
Check out: JPMorgan says bond-market rally faces risk of ‘tantrum’ like 2013 and 2016
Also see: Could the Fed surprise the stock market by skipping a July rate cut? It isn’t out of the question
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