High-yield credit has recently rallied, but the setup for junk bonds doesn’t look promising, according to Morgan Stanley’s wealth-management division.
“While the drop in U.S. Treasury rates on optimism about inflation and the pace of Federal Reserve hikes should benefit credit, the outperformance of high yield appears outsized versus historical patterns,” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, in a note Monday. “The recent risk-on bear market rally has taken high yield credit up along with stocks, with high yield outperforming the higher-quality and lower-beta investment grade index since midyear.”
High-yield debt’s outperformance of investment-grade bonds historically has followed the Conference Board Leading Economic Index for the U.S., according to the note. Shalett highlighted a chart in the report suggesting that high-yield is “getting ahead of itself.”
“Most recently, with economic data exhibiting a slowdown, leading indicators have hooked negative, with recession odds rising materially,” said Shalett. “Typically, this has not been the setting for high yield to outperform.”
The Conference Board said last month that the U.S. leading economic index fell 0.8% in October, marking an eighth straight monthly decline.
Meanwhile, the iShares iBoxx $ High Yield Corporate Bond ETF has gained 5.4% on a total return basis since the end of June through Friday, beating the iShares iBoxx $ Investment Grade Corporate Bond ETF’s 1.2% return, FactSet data show. High-yield debt is rated below investment grade, or in so-called junk territory.
U.S. stocks also have rallied since midyear, with the S&P 500 index up 8.4% based on FactSet’s total return data through Friday.
But both stocks and bonds are down so far in 2022, after tumbling amid fears over the Fed’s aggressive monetary policy aimed at fighting high inflation.
This year, the S&P 500 has dropped 13.3% on a total return basis through Friday, while the iShares iBoxx $ High Yield Corporate Bond ETF was down 9.1% and the iShares iBoxx $ Investment Grade Corporate Bond ETF tanked 15.1% over the same period, according to FactSet data.
Investors tend to worry about riskier high-yield debt in an economic downturn as some junk-graded corporate borrowers may struggle to meet their debt obligations as earnings fall.
“We would upgrade in quality and find alternative sources of safer default-adjusted yields in the investment grade universe,” said Shalett.
Shares of the iShares iBoxx $ High Yield Corporate Bond ETF
were down around 0.7% in early afternoon trading Monday, while the iShares iBoxx $ Investment Grade Corporate Bond ETF
fell 1%, according to FactSet data, at last check.
The Fed has been trying to cool the U.S. economy without tipping it into a recession.
The U.S. stock market was trading sharply lower Monday, as investors weighed fresh economic data showing activity in the services sector was stronger than expected in November. The S&P 500
was down 1.6% in early afternoon trading, while the Dow Jones Industrial Average
fell 1.2% and the technology-heavy Nasdaq Composite dropped 1.7%, FactSet data show, at last check.
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