The Federal Reserve’s looming rate cuts are fueling a rally in the riskiest corner of the US corporate bond market, but some investors are concerned the party may not last.
On Wednesday, the Fed is expected to cut interest rates for the first time in four years. Signs that the US economy is slowing and inflation cooling have prompted some bond traders to call for up to a half-point interest-rate cut. As risk markets have broadly rallied, junk bonds have gained 7.4% this year, and have outperformed Treasuries in recent weeks, with spreads narrowing 69 basis points, or 0.69 percentage point, since Aug. 5.
Amid this rally, the riskiest debt is gaining the most. Spreads on CCC rated debt, the lowest tier that usually trades, have tightened for seven straight sessions through Tuesday’s close, reaching 685 basis points. That’s their narrowest since April 2022, toward the start of the Fed’s latest tightening campaign.
“High yield bonds are extremely overvalued, plain and simple,” according to Marty Fridson, chief executive officer at FridsonVision High Yield Strategy, and a veteran strategist at firms including Morgan Stanley and Merrill Lynch.
Fridson’s valuation analysis is based on inputs including credit availability, capacity utilization and industrial production, the default rate, and the Treasury market. According to his model, the market is overvalued by more than one standard deviation.
The long-awaited rate cuts expected to start on Wednesday should make it easier for CCC rated companies to access debt capital markets, rather than filing for bankruptcy as their existing debt comes due. But the Fed is also trying to manage the growing signs of slowing economic growth, a weakening that could weigh on companies with high debt loads.
Bill Zox, a portfolio manager at Brandywine Global Investment Management, says it’s hard for investors to stay disciplined in such an environment.
“It should not come as a surprise that the financial markets might be overdoing it before the rate cutting party has even begun,” he said in an interview. “The Fed should, but probably won’t, tamp down on that exuberance.”
Having said that, Zox regards most of the high-yield market as “very healthy” at the moment. He emphasizes that the “real danger” lies in the riskiest portion of the market. Less aggressive rate cuts or a more severe economic slowdown would make it harder for troubled companies to work their way out of very difficult situations, he added.
“We’re getting into a dangerous territory,” Zox said. “Idiosyncratic risk that is not stressed is where the best opportunities are.”
Some CCC rated issuers don’t deserve to have 700 basis points spreads, according to Hunter Hayes, chief investment officer at Intrepid Capital Management and a co-lead portfolio manager of the Intrepid Income Fund.
“There’s a steady drumbeat to look for the next thing with yield that inevitably leads you to CCCs,” said Hayes. “That’s a dangerous dynamic and it’s the reason that you have to do your homework because inevitably there will be potentially some high-profile defaults within that CCC bucket.”
Still, there’s “building enthusiasm” in the junk market for the impact rate cuts could have on businesses with highly levered capital structures, according to Eric Williams, head of capital structure and senior portfolio manager at Northern Trust Asset Management. That’s both broadly in terms of all-in treasury yield levels over the next year, and specifically for those companies with mainly floating-rate capital structures.
When combined with the pick-up in mergers and acquisitions activity lately, those factors are all supportive of CCC rated debt, which is “performing extremely well at the moment,” he added.
Issuers like Hightower Holding LLC and Garda World Security Corp. have recently capitalized on favorable funding conditions to issue CCC rated debt that will help finance mergers and acquisitions, and more issuers may follow as yields fall. Recent M&A-related reports have sparked rallies for Dish Network Corp. and Frontier Communications bonds, with the issuers among the biggest contributors to CCC returns this month, according to data compiled by Bloomberg.
Williams is constructive on the economy and comfortable with mid-tier and potentially higher-quality, lower-rated securities that offer compelling risk-adjusted returns over the next 12 months.
“Dispersion is very high in the high-yield market and as a result of that, there is significant opportunity across cyclicals and non-cyclical as well, given the state of the consumer and the overall state of the economy,” said Williams.
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