Bond investors are coping with recession anxiety, extreme volatility

By Joy Wiltermuth

It took only about a week for riskier U.S. corporate bonds with 'junk' credit ratings to erase all of their gains this year

Investors in the U.S. bond market have been facing extreme volatility sparked by an uproar in the currency markets and growing anxiety over the state of the U.S. economy.

In just one example of the tumult, it took only about a week for riskier U.S. corporate bonds with "junk" credit ratings to erase all of their earlier gains this year.

Spreads on high-yield corporate bonds jumped by about 80 basis points to more than 370 basis points above risk-free Treasurys. The move intensified following Friday's surprisingly weak U.S. jobs report, which saw the unemployment rate climb to 4.3%, a three-year high. That also triggered the Sahm rule, a closely watched recession gauge.

Monday saw a violent selloff in global equity markets as the popular Japanese yen (USDJPY) "carry trade" started to unravel, an explosion of volatility VIX hit financial markets and a temporary pause was placed on new corporate borrowing.

But on Tuesday, several major U.S. companies were back looking to borrow some $5 billion in the corporate bond market, seizing on a rebound in equities SPX DJIA COMP and recent easing in Treasury yields.

Toyota Motor Corp. (TM) and six other fairly defensive companies on Tuesday were slated to price 10 tranches of bonds, according to Informa Global Markets. Informa pegged Monday's pause as one of only 14 similar sessions this year to see no new debt issuance.

'Dipping their toes back in'

"High-quality companies are dipping their toes back in" the bond market, said George Catrambone, head of fixed-income, Americas at DWS - adding that the investment-grade markets "are back open for business."

Yet it looks to be a careful reopening with strings attached. Catrambone expects borrowers to pay slightly higher new-issue concessions than earlier this year to tap the market for financing, and for volatility and recession fears to be taken more seriously by investors.

"There are plenty of things to be nervous about," he said, pointing to the U.S. election in November and tensions in the Middle East, but also concerns about global growth and how well the labor market will hold up relative to the past few years.

On the flip side, the recent sharp repricing of the $27 trillion Treasury market has real implications for borrowers and the economy. The benchmark 10-year Treasury yield BX:TMUBMUSD10Y was at 3.88% on Tuesday, a day after it fell a dramatic 50 basis points over only eight trading days, according to Dow Jones Market Data.

"Once volatility steadies out, you see issuers run to lock in lower all-in borrowing costs, because on the investment-grade side of the puzzle you are seeing inside of 5% yields for the first time really since the spring of 2022," said Blair Shwedo, head of fixed income and trading at U.S. Bank.

A careful path ahead

Like U.S. households, both high-yield and investment-grade companies were busy in recent years terming out as much debt as possible at low pandemic-era rates. That provided a buffer while the Federal Reserve dramatically raised interest rates, as well as the ability to bide their time until rate cuts emerge.

"With the moves you had, the worry is always that if a tech correction continues, it could become an actual problem for the economy," said Adam Farstrup, head of multiasset, Americas at Schroders. The most obvious way that could happen would be through a freezing of credit markets on Wall Street, he noted.

"The tone of trading we are seeing today is in line with a technical correction," Farstrup said. "But the market is going to have to watch things carefully in the coming days and weeks."

While many investors have been anticipating rate cuts to start potentially in September, other outcomes beyond the Fed achieving an economic soft landing have also emerged on the radar as possible outcomes.

"I don't think a recession is imminent yet," said Tracy Chen, a portfolio manager on the global fixed-income team at Brandywine Global. But she added that if the economy slows down more than anticipated, she thinks the Fed would respond with rate cuts that could benefit bonds - especially high-quality segments of the market, like agency mortgage-backed securities.

Part of Chen's thinking is that Fed rate cuts may tempt more people out of money-market funds that have been paying roughly 5% and back into bank deposits. That, in turn, could bolster the ability of banks to return as buyers to agency MBS.

But even riskier high-yield bonds may be poised to hold up better than in the past if the economy slows, according to Mike Mullaney, director of global markets research at Boston Partners. He pointed to higher cash and recovery levels in the sector, but also lower default rates and leverage.

"All in, there may be less risk in the high-yield bond market than in recent years," Mullaney said.

-Joy Wiltermuth

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08-10-24 0741ET

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