With investors yanking money from corporate bond funds at the fastest pace in years, the FT's Dan McCrum argues that the unspoken question is when, not if, the economic cycle in credit markets starts to turn.
Produced by Filip Fortuna. Filmed by Petros Gioumpasis.
As investors yank money from corporate bond funds at the fastest pace in years, the wrong question to ask is if this might mark a long awaited turn in credit markets. Predictions of widespread defaults, investor losses, or a stampede out of funds which invest in high yield corporate bonds have repeatedly proven premature. The last peak of concern came in February 2016, as the oil price crashed and confidence in emerging market economies evaporated. Yet since then, the US junk bond market has been a money-making machine, reliably delivering profits as the so-called spread, the difference in borrowing costs between the government and highly indebted companies, has shrunk.
November is on track to be only the fourth money-losing month since, judged by the excess investment return from holding corporate bonds instead of treasuries. Profits in the good months have outweighed any losses so far. A better question then, is what opportunities are on offer? What is the potential return set against well-publicized risks of losses when the market turns down again? The answer is not much if past peaks are a guide.
The junk bond market is tiered by the assessed quality of borrowers, and bond markets have rarely been more favourable for many of these ranks of companies. BCA Research has calculated the proximity of these credit tiers to the all-time lows for spreads in terms of the monthly appreciation investors have become used to. Ba-rated bond spreads are three months from reaching their all-time most expensive level. Riskier single B-rated bonds have four months to go. Stepping down to C-rated, the market can experience another five months of average spread tightening. But records can be broken, of course.
The argument to invest in bonds issued by highly indebted companies starts to get a bit challenging, however, without capital appreciation. Assume spreads stay where they are, and default losses are 1% in the next year. The expected excess return of equivalent treasuries would be 2.6%, BCA calculates. Not an enormous amount of reassurance when the unspoken question is when, not if, the economic cycle starts to turn.