For the latest confirmation of the upside down market, look no further than corporate bonds where the riskiest, CCC-rated junk bonds are set to make a positive return for the 3rd consecutive year, the longest winning streak since records began in 1997.
Not only have the lowest quality junk bonds, those rated CCC or lower, generating respectable absolute returns of 5.8% YTD, they have also outperformed higher quality debt with a 1% total return so far this month, according to Bloomberg and ICE data. Additionally, the lowest rated junk bonds have also outperformed the broader junk bond index, which has returned 1.9% YTD.
And while the key contributor to the outperformance of lowest-rated bonds is demand for, well, higher yielding paper as investors continue to chase returns, a key structural issue has been the lack of HY supply, which at $150 billion YTD is the lowest since 2009.
Meanwhile, as investors scramble for any paper that promises a material yield, regardless of underlying fundamentals, investment grade corporate bond returns have, in the worlds of Bloomberg’s James Crombie “fallen from darling to deadbeat.”
Continuing a theme we first highlighted in June, when we showed the “odd divergence” of IG bonds spreads widening even as junk bond spreads touched record lows…
… junk bonds have continued to enjoy unprecedented demand (and the abovementioned record winning streak) while high grade corporate bonds are set for their worst year since 2008, with returns for the space down 2.34% so far in 2018.
As shown in the chart above, while high-grade bond returns have been mostly positive since the financial crisis, the increasingly hawkish Fed has taken its toll this year, and with three rate hikes in the rear-view mirror and more to come, investors are getting out of low-yielding fixed-rate bonds – which traditionally underperform in rising rate environments as yields increase across the board – choosing either junk bonds or floating rate loans. No surprise then that the best performing asset classes in credit include high-risk, high-yield CCC debt and floating-rate leveraged loans.
Curiously, the negative returns for IG bonds – which have been largely used to finance another year of record mergers – haven’t resulted in lower demand or slowed new issuance: according to Bloomberg, September was the highest volume month of 2018, with $122.7 billion pricing so far.
As Crombie summarizes these trends, “investors are like all others – they pursue returns. That means more money chasing a limited supply of increasingly risky bonds, and probably an uglier end to this credit cycle.“
His Bloomberg macro commentator partner, Seb Boyd adds that “if the Fed halts rate rises, and corporate decision makers collectively take a sober decision to invest in long-term organic growth, then investment-grade corporates will benefit.”
However, if extra Treasury sales push up yields, or late-cycle CEOs look at PE valuations and decide this is a good moment to go shopping, then high-rated bonds are best avoided.
Meanwhile, as junk bond supply remains subdued, the ongoing record wave of mergers, most of which are funded with IG debt, will see no shortage of lower-yielding paper; additionally high grade bonds will increasingly face a lot of competition, especially if the Fed keeps hiking rates and shrinking its balance sheet. This will continue until, eventually, the Fed triggers an “event” that forces a broad market repricing, one which see staggering losses in junk, and forces yield chasers into more safe places along the capital structure.