May 11, 2022 - Economy & Business

The credit sell-off has been steep, but orderly

Data: ICE BofA U.S. High Yield Index via FRED; Chart: Axios Visuals
Data: ICE BofA U.S. High Yield Index via FRED; Chart: Axios Visuals

Corporate bonds have had a tough year. The rout has been difficult to stomach: high yield bond funds, for example, have returned a negative 10% since the new year, while investment-grade funds are down 13%.

Why it matters: Swift losses can make it feel like markets are on shaky ground — especially given the risks built into the Federal Reserve’s monetary tightening mission. But underneath the hood, there are signs that corporate yields are rising in a pretty orderly fashion.

State of play: For one thing, the lowest-quality, most risky corporate bonds haven’t sold off disproportionately compared to the safer ones. (As bond prices go down, yields go up.)

  • The chart above shows the gap, over time, between average yields on CCC-rated bonds (the most risky) and higher-rated BBs. During the last two periods of market indigestion from Fed tightening — 2016 and 2018 — the gap between the two was much wider, often at double digits compared to around 6 percentage points now.
  • Same goes for periods of economic stress like the onset of the pandemic in early 2020, and the financial crisis in 2007.

“That points to the fact that credit really hasn't cracked,” Matt Nest, global head of fixed income at State Street Global Advisors, tells Axios. “The sell-off has been relatively orderly to date, which is a sign of health.”

  • Still, he acknowledged that “we have to be looking forward and say, ‘Is it coming but just hasn’t happened yet?’”

Meanwhile, although yields have zoomed up, on an absolute basis they’re still short of various high points over the past few decades.

What to watch: That means there’s undoubtedly more room for bond prices to decline further — and for the spread between CCC and BB bonds to expand.

  • This is one thing credit investors will be paying close attention to in the coming months as the Fed starts shrinking its balance sheet, says Peter van Dooijeweert, managing director of multi-asset solutions at Man Group’s Man Solutions.
  • “It's always been bad when you take the liquidity out. And the size of the balance sheet is enormous,” he says. (The Fed's balance sheet more than doubled, to $8.9 trillion, since the beginning of the pandemic.)

The bottom line: The recent rise in yields is the natural result of a move toward tighter money. Broadly speaking, it's what Fed officials were aiming for.

  • The next test for credit markets will come if cooling economic growth starts to impact corporate earnings. The most vulnerable, highly levered companies — the CCC rated — may be the first to tip into financial distress. And then risky bond yields could really climb.
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