Junk bond nervousness may signal the start of a market capitulation

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Investors worried about the recent market turmoil may want to keep an eye on the nearly $ 1.5 trillion high yield corporate bond market, to help determine when a bigger selloff on Wall Street might begin.

Analysts often view high yield market declines, or “junk-bonds,” as a canary in the coal mine, or as an early warning when investors might start shying away from riskier assets.

The main drivers of recent nervousness have been a bitter fight against the next Supreme Court judge, dampening the prospects of another fiscal stimulus package, the potential for a contested presidential election after November 3 and the persistence of the COVID-19 pandemic – all threatening to crack the foundation of recent market gains.The logic behind why investors should watch high yields for signs of trouble is that bad bonds are typically sold by America’s most indebted companies, leaving those debt holders vulnerable to changing expectations about the recovery. American economy.

That’s why, during Monday’s steep market sell-off, market participants focused on the sharp exits into the high yield sector as a sign that things could easily get uglier in the coming months.

Specifically, the largest exchange-traded fund focused on sub-investment grade debt, iShares $ High Yield Corporate Bond, HYG,
-1,01%,
was hit by nearly $ 1.06 billion in capital outflows on Monday, the largest one-day outflow since the start of the pandemic.

“Our feeling is that a further weakening of HYG would be the signal to confirm real risk aversion,” Arnim Holzer, macro and correlation defense strategist at EAB Investment Group, said in a note Tuesday.

The ETF closed Wednesday trade 1% lower at $ 83.04 a share, leaving it down 1.4% so far this week, according to FactSet data.

It is perhaps not surprising that stocks have also seen big declines this week. The S&P 500 SPX index,
-2,37%
ended Wednesday down 2.4%, while the Dow Jones Industrial Average DJIA,
-1,92%
fell 1.9%.

In another sign of nervousness in the high-yielding natural gas sector, Texas-based natural gas company Aethon United BR LP has postponed its planned sale of $ 700 million high-yield bonds, reported Wednesday. Bloomberg News, while ranking it as the first US bond financing to be snatched since July. A call to Aethon for comment was not immediately returned.

Still, some investors believe that much of the recent turmoil and high-yielding capital outflows may simply reflect cautious fund managers putting money aside in anticipation of more attractive opportunities around November, when equity prices. bonds could fall due to the volatility of riskier assets.

In other words, the sudden crunch in credit and capital outflows could be a sign of choppy waters ahead, but not necessarily wholesale carnage or a return to the temporary credit freeze seen in February as the pandemic s originally fell on the United States.

“I think it was the right decision,” said Rob Daly, director of global fixed income at Glenmede Investment Management, in an interview.

Daly pointed out that US high yield debt has already factored in many pandemic stimulus measures and could be vulnerable to the lingering standoff between members of Congress and the White House over additional tax measures to offset the toll. pandemic, given the political crisis landscape.

Even so, the sector’s safety net remains the Federal Reserve itself, which began buying corporate debt during the pandemic for the first time in history, including acting as a creditor to recent “Fallen angels” or companies that have seen their credit ratings drop from the coveted investment grade range into junk bond territory.

Related: The Fed bought $ 8.7 billion worth of ETFs. here are the details

The recent weakness in junk bonds followed a broad bullish sentiment in corporate debt for much of the past six months, which only now could reverse.

The issuance of new US junk bonds this year broke previous records, even as yields approached pre-pandemic lows in February and US corporate debt hit new records.

But even last week, investors were still looking to the most battered segments of the industry, narrowing the spreads between its highest-rated and lowest-rated bonds along the way.

For example, the yield spread between double B and triple C bonds was down to 11.69 percentage points on Monday, from almost 20 percentage points in March.

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