Investors pulled $6.1 billion from junk-bond funds last week, but there were bigger outflows in February, the last time stocks tumbled. Photo: Peter Morgan/Associated Press
As Treasury yields rise, corporate bonds are getting whipped by the storm. But there’s still a danger investors aren’t getting paid enough for the risks they are taking.
A close look at U.S. bond markets reveals little evidence of a systemic flight from risk amid last week’s ructions. Yields haven’t yet risen much compared with recent years even as investors have withdrawn billions from corporate-bond funds.
Moreover, safer investment-grade bond funds have suffered more than sub-investment-grade or junk ones. Investors pulled a record $7.5 billion from investment grade funds and ETFs last week, according to Bank of America Merrill Lynch. They also took $6.1 billion from junk-bond funds, but there were bigger outflows in February, the last time stocks tumbled.
All year, investment-grade bonds have performed worse than riskier debt. The spread—the extra yield they pay compared with Treasurys—has been on an upward trend since February, according to the ICE BofAML U.S. investment grade index.
Meanwhile, the spread on junk bonds hasn’t yet increased enough to break out of the generally downward trend that has lasted almost three years. The spread is up by more than 0.4 percentage points since its low point at the start of October on the ICE BofAML U.S. High Yield Index, but remains below where it traded most of the period before May this year. Of course, the total interest cost for junk bonds is greater than it has been since late 2016 because Treasury yields have been driven higher by rising U.S. interest rates.
This contrast between the performance of safer and riskier debt suggests investors aren’t yet fleeing risky assets in general. But it also has a lot to do with the relative mix of credit ratings.
Bonds rated BBB—the lowest for investment-grade debt—make up half the investment-grade index, the most in more than 15 years. For investors, that means greater risks of downgrades to junk status and hence losses. Meanwhile, the junk index has an unusually large share of BB-rated bonds—the best junk rating—because the really risky companies have been borrowing in booming loan markets.
The good news is that investors have some idea of this, which is why a bigger gap is opening up between spreads on BBB-rated bonds and AAA-rated bonds.
However, given that the U.S. and global economies are very far into a long period of growth and more interest-rate rises are in the cards, investors should be more concerned that they aren’t getting paid enough for the risk of downgrades and, potentially, defaults when the slowdown comes.
The selloff in corporate debt has barely started.
Write to Paul J. Davies at [email protected]