Corporate bonds have leapt out of the starting gate to begin 2023, a salve to investors who suffered double-digit losses last year.
Company bond prices have climbed and their yields have declined, particularly in relation to those on low-risk government notes. That reflects traders’ improving conviction that businesses will withstand any coming economic downturn with limited stress. The gains have erased a portion of last year’s miserable results for fixed-income markets, which cracked many long-held Wall Street strategies for ensuring stability in investors’ portfolios.
Intercontinental Exchange’s index of investment-grade corporate bonds has returned 3.1% so far this year, including price changes and interest payments. Junk-rated bonds, which are below investment-grade, have done better, adding 4.4%.
That is a reversal from last year, which mostly saw bond yields rush higher at every turn. Yields rise as bond prices fall.
Twin threats pummeled prices in 2022: rising interest rates, which slashed the value of lower-yielding bonds already in the market, and fears of a recession, which scared off some investors from lending to businesses that might struggle to repay debt. ICE’s high-yield and investment-grade indexes lost 11% and 15% last year respectively.
In recent weeks, however, investors have wagered that both of those challenges are receding. Following last week’s Federal Reserve meeting, bets in futures markets showed that traders grew more convinced the Fed is approaching the end of its series of rate increases. They have even been projecting—contrary to the Fed’s own forecast—that the central bank will switch to cutting rates before the end of the year.
Friday’s rock-solid employment report jostled that outlook, forcing investors to consider whether the Fed may still need to raise rates further to cool the economy. The surprisingly strong data brought a reminder that the economic outlook remains highly uncertain, said Michael Chang, a portfolio manager at Vanguard. Bonds declined in subsequent trading.
The falling unemployment rate, however, also added to evidence that a deep downturn remains far off. This month, the extra yield—or spread—that investors demand to hold junk bonds instead of U.S. Treasurys has fallen to less than 4 percentage points, well below levels that represent serious concerns about defaults. Junk-bond spreads topped 10 percentage points in the early days of the Covid-19 pandemic, and rose above 20 percentage points during the 2008 financial crisis.
Stronger corporate balance sheets—as reflected in higher credit ratings—mean that risks are lower in this economic cycle than during past downturns, Mr. Chang said. But it remains too early to sound the all-clear, he added.
“Given where spreads are today, they don’t leave much scope to absorb many negative surprises,” Mr. Chang said. He has been favoring high-yield bonds from industries that are still benefiting from a pandemic recovery, such as airlines and cruise lines, while avoiding sectors such as housing where demand is receding as the pandemic fades and interest rates rise.
Smoothing the outlook for bonds this year is a dearth of coming debt maturities. Investment-grade and junk-rated companies alike rushed to take advantage of cheap borrowing costs during the pandemic, resetting the clock on when they must refinance their debt.
About $106 billion of high-yield bonds are set to mature this year and next, compared with $881 billion between 2026 and 2029, according to Goldman Sachs research. That suggests a near-term recession wouldn’t coincide with large funding needs for risky borrowers, muting the potential for a credit crunch.
Last year, a slowing housing market, declining consumer spending, layoffs at some big tech companies and warning signs in the government-bond market all sparked concerns that a recession could be nearing. But credit risks for even junk-rated companies might be more benign under the surface, the Goldman’s researchers found.
Their analysis of borrowers’ financial statements concluded that the default rate among junk-rated companies may hit 2.8% this year, a rise from recent months but well below the levels reached during past recessions.
This year’s falling yields have somewhat reduced companies’ borrowing costs, enticing some corporate finance chiefs to raise funds by selling new bonds despite rates that remain relatively high overall. Junk-rated companies typically sold new debt at yields of 8.5% in January, down from more than 12% last fall, according to Leveraged Commentary & Data.
Low-rated companies issued $20.6 billion of bonds last month, helping to thaw 2022’s frozen fundraising market, LCD’s data show. The Fed’s rapid interest-rate increases warded off borrowers last year, capping issuance below $10 billion in every month from May through December.
Borrowing has jumped out to a solid start in February. A $2 billion investment-grade bond sale from Northrop Grumman Corp. and a $750 million junk-rated offering from Albertsons Cos. contributed to more than $15 billion in new issuance across the two markets on Monday alone.
Healthy volumes of low-rated debt issuance are welcome news to investors looking for deals, because greater supply can push down bond prices and lift yields, said Sean Feeley, a fixed-income portfolio manager at Barings. Mr. Feeley said that at spreads of less than 4 percentage points, junk bonds may not be adequately compensating investors for the risk that corporate earnings could falter later this year.
“There has just been a relentless bid for risk so far this year,” Mr. Feeley said. “We’ve been pining for more new issuance to sop up this excess demand.”