Trading in U.S. risky corporate bonds kicked off 2023 on an upbeat note, with investors tolerating a smaller premium to hold lower-grade debt as evidence of cooling inflation.
U.S. speculative-grade bond yields fell about 0.8 percentage point in the first two weeks of January to just over 8 percent, according to an ICE Data Services index, signaling rising debt prices.
Borrowing costs for the groups with the lowest credit quality fell further, according to the icy gauge of distressed debt, sliding about 3 percentage points to 19.3 percent, the last seen five months ago.
Those improvements follow a big selloff in subprime bonds and other riskier asset classes last year, when the U.S. central bank quickly raised interest rates.
This month’s move partly reflects rising U.S. government debt, fueled by expectations that the Federal Reserve will soften its stance against aggressive rate hikes amid slowing prices. The decline in benchmark Treasury yields has boosted the appeal of lower-rated corporate bonds, which typically offer higher yields.
The yield gap between junk bonds and Treasuries has also narrowed since early January, in a sign that investors are betting on a more favorable economic backdrop and a reduced risk of default.
The spread on US high-yield bonds tightened by 0.5 percentage points since the end of December and reached 4.29 percentage points on January 12.
Matt Misch, head of credit strategy at UBS, said inflation “in balance” has recently surprised investors “to the point of recession”.
Data on Thursday showed that the US consumer price index weakened for a sixth straight month in December, to 6.5 percent.
Meanwhile, “you can describe the net growth data as mixed” for the world’s largest economy, Misch said. “That’s why I think inflation data and expectations about how that flows into Fed policy. . . That’s really what the market is focused on.”
The latest narrowing of credit spreads comes even as the Treasury yield curve — the difference between two-year and 10-year government bond yields — remains inverted, which investors generally see as a sign of a prolonged economic downturn.
When there was a brief but sharp downturn in 2020 in the depths of the coronavirus crisis, the US high-yield spread rose above 1,000 percentage points.
“I think it’s very difficult to argue that we’ll go all the way through 2023 without some significant spread expansion,” said Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors.
“I don’t think Treasury rates will drop enough to compensate [2, 3 or 4 percentage point] expansion,” he added, pointing out that default rates are expected to rise.
“If spreads tighten at the end of the month, that will be one positive point for the rest of the year,” UBS’s Misch said.
Friedson noted that the high-yield market “doesn’t have a great record” of providing a reliable warning well in advance of a recession.
“Naturally, people seem to stick with it, maybe overstaying their welcome, thinking,
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