Junk-Bond Rebound Signals Easing Fear

Strong economic signals from US high yield market.

Source: Wall Street Journal

The riskiest part of the U.S. corporate-bond market is staging a comeback, marking an upswing in investor confidence following a turbulent start to the year.

Returns on junk bonds, debt issued by heavily indebted companies that carry low credit ratings, turned positive for 2016 this month, reversing a sharp selloff at the beginning of the year. Investors poured nearly $5 billion into junk-bond mutual funds and exchange-traded funds in the week ended March 2, the biggest such inflow on record, according to data from Thomson Reuters Lipper.

The revival is noteworthy because the junk-bond market is widely watched for clues about the state of the U.S. economy. Companies issuing junk debt have less financial flexibility to weather a downturn than higher-rated firms, often making the performance of their bonds an indicator of broader economic health.

The junk-bond surge is among the most convincing signs that the recession fears that rattled markets earlier this year have faded. Starting in late 2015, junk bonds were hit by heavy selling, the closure of a fund overseen by Third Avenue Management LLC and deepening commodity-price declines.

But since mid-February junk-bond prices have surged alongside those of other risky assets, such as stocks and commodities, reflecting a rosier view of the global economy and receding risk of a U.S. recession. While analysts continue to scrutinize stock valuations amid soft global-growth expectations and slumping U.S. corporate earnings, many portfolio managers say stocks and junk bonds look relatively attractive at a time when yields on safe assets such as government bonds are near record lows and falling, in many cases.

On Monday, the Dow Jones Industrial Average rose 67.18 points, or 0.4%, to 17073.95, led by a gain in energy shares, as crude prices extended a rebound. U.S. oil prices have climbed 45% off a 13-year low reached in February, as investors have focused on talks among producing nations about freezing output and expectations that U.S. production will keep falling. On Monday, crude futures in New York rose $1.98, or 5.5%, to $37.90 a barrel. In the metals markets, the price of iron ore rallied almost 20% Monday as traders bet on rising demand from China for the steelmaking ingredient.
At the same time, signs of disquiet remain. The 10-year U.S. Treasury yield is below 2%, reflecting an expectation that many investors will continue to seek out havens amid a general increase in volatility.

Junk bond prices rose slightly on Monday, with one ETF that tracks the market recording a 0.1% increase. Even as the rally enters its fourth week, there are indications that the market isn’t at full strength. Sales of new junk bonds have plummeted, indicating some hesitancy among investors that can be also seen in the market for initial public offerings of U.S. stocks, where sales have similarly dropped off.

Still, many investors are optimistic that junk bonds will perform well in the coming months, as U.S. growth continues and interest rates remain low, making the juicy yields on junk debt even more attractive.

“The main drivers are going to be what’s going on in the economy, and the economy, it’s OK,” said Andrew Susser, who oversees the $8.5 billion MainStay High Yield Corporate Bond Fund. “Housing numbers are steadily improving. Auto sales are strong. The consumer’s got a lot of cash and has been paying down debt.”

In a particularly encouraging sign, one of the lowest rungs of the junk-bond market, debt from companies rated triple-C, has rallied significantly in recent weeks.

Trading volumes are also higher than average, suggesting there is more conviction among investors about the direction of the market. Since mid-February, an average of $10.3 billion in junk bonds have exchanged hands, compared with an average of about $8.2 billion over the previous 13 months, according to data from MarketAxess Holdings Inc.
Some investors say junk-bond prices are still low enough relative to market benchmarks that they are a good buy. As of Friday, the yield gap between junk bonds and benchmark U.S. Treasurys was 6.69 percentage points, compared with the 10-year average of about 5.9 percentage points. A higher gap, called the spread, means investors are getting larger interest payments to compensate them for the risk of default.

Michael Ball, lead portfolio manager at Weatherstone Capital Management in Denver, which oversees $500 million, said he has been increasing clients’ allocation to junk bonds by buying ETFs whose holdings seek to mirror major junk-bond indexes. He said the wide yield gap compared with historical averages was a motivating factor.

Mr. Ball said he was also encouraged by recent stability in oil prices, which plummeted along with other commodities starting in mid-2014 and led to an increase in defaults from junk-rated energy firms.

“If you see oil prices stabilize, and you have a smaller-than-expected number of defaults coming out of the energy sector, I think it’s one of the most attractive buying opportunities we’ve had in high yield in a number of years,” Mr. Ball said.

Analysts said some oil and mining firms, whose bonds had fallen sharply earlier in the year, were among the best performers over the past few weeks as commodity prices rallied. A 2022 bond from Oasis Petroleum Inc. was trading at 50 cents on the dollar in February and has now climbed back up to 72 cents. Another 2022 bond from Freeport-McMoRan Inc. was also trading around 50 cents in February and is now at 74 cents.

To be sure, the junk-bond market still faces challenges. Sales of new debt have yet to recover and are about $17 billion in 2016, a more than 70% drop from this time last year, according to LCD, a unit of S&P Global Market Intelligence. A recent deal led by Goldman Sachs Group Inc. for the leveraged buyout of Solera Holdings Inc. took longer than expected to complete and had to offer higher yields to entice investors to participate.

Patrick Flynn, who helps oversees the $3.7 billion Neuberger Berman High Income Bond Fund, said his fund bought bonds from certain industries such as pipelines before and during the recent rally.

“The biggest risk to the market is clearly just the U.S. economy,” he said. But he added: “We are not getting data from companies and in conversations with management teams that would indicate a broad-based U.S. recession.”