Market Extra: Junk-bond spreads see sharpest monthly selloff since September 2020

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Even with the debt boom by high-risk companies during the pandemic, the costs of borrowing in the U.S. bond market have been mostly dwindling since March 2020, when credit briefly froze.

At least until July, when U.S. corporations with non-investment grade, or “junk-bond,” ratings booked their worst monthly selloff, on a spread basis, since September 2020.

Junk bonds can serve as a canary in the coal mine, in terms of selling off quicker than other mainstream parts of the debt and equity markets. So, is now a good time to start worrying as the pandemic enters another potentially dangerous phase?

“I think a lot of it is being driven by the Treasury market,” said Kevin Nicholson, co-chief investment officer of fixed income at RiverFront Investment Group, a firm with about $9.1 billion in assets under management, pointing to the 10-year Treasury rate’s
TMUBMUSD10Y,
1.174%

20-basis-point slide in July. Spreads are the level of compensation investors earn on a bond above a risk-less benchmark like Treasurys, to compensate for its default risk.

“There might be a little bit of spread-widening because people are concerned about growth potentially slowing going forward,” he told MarketWatch. “If growth slows down, that is going to hurt those companies because that could potentially cause credit conditions to tighten up. But as of right now, I am not seeing high-yield giving us any signals to be worried about anything.”

Junk bonds, also called “high-yield,” saw spreads widened by 29 basis points last month to about 332 basis points above Treasurys, according to the ICE BofA U.S. High Yield Index — the most in a month since September 2020, when spreads gapped out by 39 basis points.

The main junk-bond exchange-traded funds, the SPDR Bloomberg Barclays High Yield Bond ETF
JNK,
+0.03%

and iShares iBoxx $ High Yield Corporate Bond ETF
HYG,
+0.11%
,
finished trade a touch higher on Tuesday. Stocks also rose Tuesday, with the S&P 500 index
SPX,
+0.82%

notching a fresh closing high.

But even with the recent widening, junk-bond spreads continue to hover near pandemic lows.

July sees spreads gap out.


Federal Reserve Bank of St. Louis

“On the junk side, small-caps
RUT,
+0.36%

got whacked also, and they tend to trade pretty tightly together,” said John Lynch, chief investment officer at Comerica Wealth Management.

Lynch attributed the July selloff to investors questioning the reflation or recovery trade as the delta variant of the coronavirus leads to another wave of infections and hospitalizations. It also prompted parts of California to tighten mask rules, while BlackRock
BLK,
+0.80%
,
Microsoft
MSFT,
+0.81%
,
Google
GOOG,
+0.21%

and other private companies recently adopted vaccination rules for workers returning to the office.

“When I do look at high-yield and investment-grade spreads relative to Treasurys, what I don’t see is credit stress,” Lynch told MarketWatch. “I’d be more worried if spreads were blowing out and Treasurys were tanking, but that is not the case.”

Lynch also note that copper futures
HG00,
-0.08%
,
up 24.5% this year, have been outperforming gold
GC00,
-0.03%
,
down 4.31% in the same stretch, as of Tuesday’s close, according to FactSet.

“I’ve been wracking my brain over this, but if copper is outperforming gold, that is global investors saying they believe the reflation trade more than they want to be parked in the safe-haven of gold,” Lynch said.

Despite last year’s record volume of U.S. corporate bond issuance, the sale of new junk bonds has continued at a rapid pace in 2021, signaling no slowdown in investors appetite for risky debt. Issuance of junk bonds was about 46% higher, at $370 billion, in the year’s first seven months, versus the same stretch last year, according to Dealogic.

Finally, investors continue to grapple with the more than $16 trillion worth of global assets now trading at negative yields, giving positive returns in U.S. corporate and government debt an edge with international buyers.

“When you look at the benchmark 10-year Treasury yield at 1.17%, that is a frightening number,” Lynch said, unless you also have been watching the 10-year German bund
TMBMKDE-10Y,
-0.479%

trade at almost minus-0.50%.

“We are less absurdly priced than the rest of the world,” he said.

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