This segment of the corporate bond market is flashing a warning that investors shouldn’t ignore

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US equities have just consolidated their worst start to the year in more than half a century. But as the slowdown in the U.S. economy becomes increasingly difficult to ignore, the high-yield corporate bond market, often known as “junk bonds,” a Wall Street nickname for debt of companies with less than stellar credit ratings – a warning blinks.

Following the market close on Thursday, the spread on Bloomberg’s high-yield corporate bond index — a measure of the risk premium demanded by investors holding the bonds included in the index — had reached its highest level. broad since July 2020. included in the index, companies must have a credit rating of “BB” or lower from Moody’s Investors Service or S&P Global Ratings.

Even loans belonging to oil and gas companies, which for a long time have been an important part of the index (recently, around 15%) have been mistreated since the beginning of the year due to of the Federal Reserve’s decision to raise its target for the federal funds rate by 1.5 percentage points since it began its rate hike cycle in March. Although these loans have outperformed many of their peers in other sectors due to rising oil and gas prices, rising borrowing costs have still weighed on prices.

Ironically, the reason high-yield bonds have been sold in recent days is the same reason that government bonds as well as U.S. Treasury bonds have recovered: fears of escalating recession are making that investors dump risky assets such as scrap debt and actions in favor of a “safe haven”. assets such as the US dollar and government bonds.

“High-yield credit spreads are widening in large part because the market has begun to fear that high inflation will force the Fed to tighten monetary policy even more aggressively, pushing the economy into recession,” he said. say Gennadiy Goldberg, U.S. rate strategist. TD Securities.

“It’s the same reason Treasury yields have declined in recent days, as markets have begun to fear that the Fed’s very disgusting rhetoric will control inflation, but at the expense of economic growth,” Goldberg added. .

On Thursday, investors faced further signs of a slowdown in the economy. The reading on consumer spending fell short of economists ’expectations, while the latest Federal Reserve Bank of Atlanta estimate for second-quarter GDP growth stood at -1%. If this estimate is correct, it would mean that the US economy has already fallen into a technical recession, which is defined as two consecutive quarters of economic contraction.

There is a good reason why investors should pay attention to high-yield loans now: market experts believe that high-yield credit spreads are a leading indicator for the economy, as investors in these credits they are especially sensitive to anything that could harm companies. ‘ability to pay off their debts. High-yield bond ETFs have already recorded their largest outflows during the first half of a year, MarketWatch previously reported. Bond yields move inversely to prices, increasing as prices fall.

“When we look at high-yield credit spreads, they are usually a key indicator, especially of how investors perceive the economy. Investors demand much more yield, much more compensation to invest in these bonds given the risks that increase “Today there is less faith in the ability of these companies to keep up with the payment of their debt than just a few months ago,” said Collin Martin, a fixed income strategist at the Schwab Center for Financial Research.

Another problem with rising yields is that they tend to be self-reinforcing: yield increases raise the cost of refinancing a firm’s debt, depriving capital firms of difficult economic times, when they need it most. As Charlie Bilello, founder and CEO of Compound Capital Advisors, pointed out in a tweet, high-yield credit spreads exceeded 10 percentage points during each of the last three recessions.

And rising credit spreads are also a problem for the underlying U.S. economy. Because this class of corporate borrowers employs millions of Americans, CEOs and CFOs often respond to higher borrowing costs and other signs of an impending recession by laying off workers and delaying investments.

“If you’re a CEO or CFO, you’re looking at what your corporate earnings outlook is like, you’ll see rising input costs, you see rising labor costs, and you see rising borrowing costs, and considering that expectations of the market for slower growth, you will probably see that the demand for your product decreases.So what do you do to successfully manage your business? stay stable or even shrink, ”Martin said. “It’s a pretty negative view right now.”

The increase in spreads has yet to translate into higher defaults, but that could change soon. Both Moody’s and S&P, the two leading providers of credit ratings for corporations and governments, expect the delinquency rate of high-yield borrowers to rise to 3% or more over the next 12 months, according to their projections.

And with the expectation that the Fed will raise its fund rate target by 150 basis points or more before the end of the year (although they continue to reduce their balance sheets), companies will quickly find that their borrowing costs they will increase dramatically, even doubling, within a course.

With rising inflation, labor costs and the cost of debt service, management is likely to be forced to endure cuts such as job cuts. In fact, job cuts are part of the Federal Reserve’s plans to curb inflation, as the central bank believes a higher unemployment rate is needed to fight inflation.

As Martin pointed out, higher borrowing costs will not affect most “junk” borrowers until they have to refinance. But borrowers who rely heavily on variable-rate products such as leveraged loans could see how the shock of higher borrowing costs will affect more quickly. Many corporations rely on both junk bonds and leveraged loans, and higher rates for those products could quickly have contagious effects on the stock market and the economy at large, Miller said.

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