Amid questions about how much fuel is left in the booming U.S. economy’s tank, investors might want to heed one of the leading indicators of a recession — credit spreads for high-yield bonds.
Bond buyers say the historically narrow gap between yields on below-investment-grade corporate debt and “risk-free” U.S. Treasurys TMUBMUSD10Y, +0.55% — in other words, investors are demanding less of a premium to hold riskier debt — reflects faith the expansion has room to run.
“The naysayers of this economic expansion don’t seem to be reflected in the credit markets,” said Jim Sarni, managing principal at Payden & Rygel Investment Management.
Analysts say credit spreads for corporate bonds issued by firms with a credit rating below investment-grade can serve as reliable economic signals. While a rapidly widening spread is viewed as a potential indicator of recession danger, a narrowing spread indicates investors are upbeat about the outlook. Before each of the past three recessions, the high-yield credit spread started to widen, according to ClearBridge Investments.
The bullish growth outlook implied by muted credit spreads runs counter to the view held by Wall Street bears that the economy’s second longest expansion since World War II will see its demise sped up by the Federal Reserve’s monetary tightening.
Reflecting the benign backdrop, junk bonds have fared well this year. The credit spread, or the extra yield paid by investors to own a basket of high-yield bonds over Treasurys, has narrowed more than 20 basis points to 3.29 percentage points this year, near its tightest level since July 2007, according to the benchmark ICE BAML bond indexes. As prices for high-yield debt rise, their yields fall, tightening the yield gap between them and risk-free Treasurys.
Bond buyers have pointed to several signs that the economy’s momentum could remain intact. After President Donald Trump enacted the a trillion dollar tax cut at the end of last year, capital expenditures have only started to climb, but remain far below levels expected during the late stages of the economic cycle, said Joe Ramos, head of U.S. fixed income at Lazard Asset Management.
A ‘few more years’
“The economy has a few more years before a recession,” said Ramos, who also pointed to tepid home building activity and the U.S.’s slow but elongated recovery since the financial crisis. Economists polled by MarketWatch expect housing starts to total 1.27 million, at cyclical highs but well below levels seen before 2008.
According to a poll of bond investors by Bank of America Merrill Lynch, a net 15% said they expected the balance sheets of high-yield issuers to deteriorate over the next six months. Though that share has gradually risen in recent months, the chart below shows fears of weakening credit quality are at levels more associated with an economy recovering from a recession than an economy about to hit the skids.
Few high-yield investors expect corporate balance sheets to worsen from now
It’s not just growth that’s fueling the upturn in high-yield debt. The improving financials of the most indebted corporations also comes on the back of recent tax cuts and a stronger outlook for monetary tightening. The Fed says it plans to raise rates two more times this year, and an additional two times next year.
Tighter credit conditions would hammer companies with excessive debt, but analysts at Bank of America Merrill Lynch said the Fed’s transparency over its rate hike trajectory has served as a shot across the bow of corporations who might be tempted to ramp up debt issuance as the economy’s prospects improve.
Also check out: Junk bonds became a ‘quiet haven’ for investors, says BAML
In addition, new rules that remove tax deductibility from interest payments at the turn of the year have also discouraged corporations from putting more debt onto their balance sheets. Those deleveraging efforts could extend the credit cycle.
“With the next recession two to three years away, higher economic growth and less use of debt — due mainly to this year’s sharp increase in the cost of debt relative to equity — corporate leverage should continue to decline,” wrote Hans Mikkelsen, a credit strategist at BAML.
As of August, issuance of high-yield corporate paper is down more than 25% year-to-date compared with the same period last year, according to data from Thomson Reuters.
But for some, the very fact that market participants are bullish on the economy is troubling.
Classic, late-cycle complacency?
“A degree of complacency is a classic late-cycle position. It doesn’t completely reassure me that some credit investors think this,” said Eric Lascelles, chief economist for RBC Global Asset Management.
That doesn’t mean investors will regret piling into high-yield debt when the next recession hits. More economists are leaning toward the view that the terminal rate of the current tightening cycle will be lower than in previous cycles thanks to weaker long-term growth from an aging population and anemic productivity. Lower borrowing costs, in turn, will mean businesses may manage debt-laden balance sheets better compared with previous recessions.
“People too quickly fall for the demise of the cycle; the overall debt levels would be an issue if you think rates would go to cyclical highs. In an aging world, we may very well be stuck with high debt levels to come,” said Arvind Rajan, head of global and macro at PGIM Fixed Income.
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