The bond market is sending mixed messages.
Credit spreads—the difference in yields between corporate debt and Treasuries—have tightened. That’s a sign of strong demand for corporates, following their 14.6% average decline in 2022, including interest.
However, bond defaults, while still low historically, are on the rise. Defaults are ticking up in the more speculative areas, such as high-yield, or “junk,” bonds. And the trend bears watching in investment-grade bonds—making an emphasis on quality debt all the more important now.
“Default risk is on the rise in investment-grade credit,” says Thomas Tzitzouris, head of fixed-income at research and advisory firm Strategas. While he isn’t expecting widespread defaults in the next year, he worries that “something we can’t yet see will become a problem.”
Defaults are extremely rare for investment-grade companies. Nicole Serino, associate director at S&P Global credit markets and insights, says that investment-grade bonds aren’t feeling the pressure of lower-rated credits, but she’s seeing “some weakening credit” in the space.
For now, stresses appear to be rising in the junk market. Fitch Ratings is forecasting a high-yield default rate of 3% to 3.5% this year for the U.S. and Canada, up slightly from the estimate issued last fall. Its new outlook reflects “growing macroeconomic headwinds” that include a recession this year.
A 3.5% junk-bond default rate—about average since 2001—would be a big jump from 2022’s 1.3%, according to Fitch.
Recent example of corporate defaults include retailer
Bed Bath & Beyond
(ticker: BBBY) and drugstore chain
Rite Aid
(RAD), notes S&P Global Ratings.
S&P also sees a jump in junk defaults, expecting a 3.75% rate by September, excluding financials, up from about 1.7% currently. Last year, just 36 U.S. issuers defaulted, the fewest since 2014. But “by no means do we think it’s going to get better,” says Serino. Companies will “find it hard to pass through their input costs, and consumers are going to continue to struggle with elevated inflation levels.”
Eric Rosenthal, senior director of leveraged finance at Fitch, describes the default pattern as lumpy. “A few names in a couple of sectors are driving it,” he says, pointing to retail, telecom, and media as sectors that could account for half of this year’s defaults.
Junk-bond defaults aren’t the only concern. Another worry is that bonds with investment-grade ratings will get downgraded as their finances deteriorate. That could push them into junk territory, making them “fallen angels,” and it could depress their prices.
None of this seems to have fazed investors, judging by the tightening of credit spreads. The ICE BofA U.S. Corporate Index recently traded at a spread of 129 basis points, or 1.29 percentage points, over Treasuries, down from 171 basis points in late October. For high-yield bonds, the spread was 433 basis points, down from 481 basis points at the end of 2022.
The junk spread “doesn’t look like a market that’s worried about a recession,” says Marty Fridson of Lehmann Livian Fridson Advisors. “But the high-yield market doesn’t have a sterling record warning of recessions with a lengthy lead time.”
How should investors position? Stick with “quality first,” says Gurpreet Gill, macro strategist in global fixed income at Goldman Sachs Asset Management. “Across fixed-income sectors, we favor investment-grade over high-yield bonds,” says Gill, though she doesn’t rule out high yield.
Within investment grade, she favors issues rated BBB. It’s the largest part of the market, accounting for nearly 60% of investment-grade bonds. “The fundamental picture is very solid,” she says. “It isn’t as strong as it was this time last year, but we’re still in a position of strength.”
One option: the $41.5 billion
Vanguard Intermediate-Term Corporate Bond
exchange-traded fund (ticker: VCIT). The ETF sports a 30-day SEC yield of 5.06%. It tracks the Bloomberg U.S. 5-10 Year Corporate Bond Index and is up 4.1% this year, including interest. Holdings recently included debt issued by
T-Mobile US
(TMUS), JPMorgan Chase (JPM),
Bank of America
(BAC), and
AbbVie
(ABBV). The fund’s expense ratio is a negligible 0.04%. (For other options, see the accompanying table.)
It’s tougher to make a call on junk bonds, which offer yields around 8%.
Danielle Poli, co-manager of the Oaktree Diversified Income fund (ODIDX), says she’s not as positive on high yield as she was in October when yields were approaching 10%, though it’s still attractive. “To get an 8% yield, versus 4.5% a year ago, provides some cushion against defaults,” she says, especially with interest rates unlikely to rise as sharply this year as in 2022, as the Fed eases up on raising the federal-funds rate.
Tzitzouris of Strategas is more cautious on high yield. He expects spreads to widen at least to their 2022 highs, pushing down bond prices, though he acknowledges “the “path there is no longer clear.” The Fed’s rate hikes are only starting to work through the economy, he adds, and it may just be a matter of time “to see what, if anything, actually broke,” due to the pressure on balance sheets.
If defaults worsen, high-yield returns would probably break, as well. While 8% yields may be tempting, investors may generate similar returns in investment-grade debt, and sleep better at night.
Write to Lawrence C. Strauss at lawrence.strauss@barrons.com
Credit: marketwatch.com