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: Watch these junk bonds for recession signals

Investors typically get skittish first about the highest-risk or most debt-laden companies going bust when recession concerns flare up.

That isn’t happening yet in the U.S high-yield, or “junk-bond” market, despite billions of dollars fleeing the sector to start 2022, the stock market’s slump, and the Federal Reserve gearing up to raise interest rates and tighten credit conditions to help tame 1980s levels of inflation.

Instead, CCC rated bonds, debt from companies considered vulnerable to default, have been holding up better to start the year than their BB counterparts, which sit right below the coveted “investment grade” category.

“If the market is going down, CCC should fall more,” said Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors, in an interview. Earlier this week he detailed the anomaly of riskier junk bonds outperforming those deemed more creditworthy, despite a tough start to the year for markets, in a report for S&P Global Market Intelligence.

“Part of it is because Treasury rates
TMUBMUSD10Y,
1.933%

have risen, and CCCs are shorter than BBs,” Fridson said. But even after adjusting for bond duration, he found the ICE BofA CCC & Lower Index still held up better, down 4.66% on the year through Feb. 11, versus negative 4.81% for the BB index.

Why? Some investors pointed to bullish factors, including the view that a U.S. economic recession sparked by a less market-friendly Fed doesn’t look imminent.

“We do not see a recession in 2022 and one is unlikely in 2023,” Ken Monaghan, co-head of high-yield at Amundi U.S. told MarketWatch. “In fact, defaults should remain below historic averages through ’22 and well into ’23,” he said of junk bonds.

The past two-year borrowing blitz by U.S. corporations also means fewer companies have debt coming due before 2025, which should minimize defaults.

Focus on Flows

Perhaps ironically, though, jitters and a rush for liquidity ahead of a Fed tightening cycle might be helping CCC rated junk bonds, as investors sell what they can without getting clobbered.

“In general, it’s definitely negative out there right now,” said Tom Cannon, credit analyst at DuPont Capital Management, by phone. “As people see red in the stock market, they start selling ETFs and mutual funds, and that further exacerbates the process.”

While bond ETFs tend to be far more heavily invested in BBs for their liquidity than CCCs, there’s also the “tourist” factor, where complex debt instruments can trade in a flash in an ETF format.

“There tends to be better liquidity in the BB side, but also when there is forced selling, it’s the only place you can find liquidity,” Cannon said.

“We aren’t in the selloff cycle,” he said, even as new high-yield bond issuance has largely stalled. “But if stocks go down 10-20% from here, and high-yield outflows continue, then you will start to see the CCCs selling off at a faster pace.”

Put another way, if CCC bonds start to wobble: look out.

The S&P 500 index
SPX,
-0.10%

was down 4.5% on the year through Thursday, while the Dow Jones Industrial Average
DJIA,
-0.21%

was off 8.1% and the rate-sensitive Nasdaq Composite Index
COMP,
-0.28%

was 12.3% lower for the same stretch, according to FactSet.

The biggest U.S. junk bond ETFs
JNK,
-0.01%

and
HYG,
-0.01%

were off 4.9% for the year.

See: Watch this ETF if Russia-Ukraine crisis erupts into war, but fund analyst says an even bigger threat for the market is panic in bonds

Energy Boost

It’s hard to talk about U.S. junk bonds without factoring in the energy sector, with forecasts for oil prices
CL00,
-2.19%

soon ticking up to $100 a barrel, particularly if Russian troops invade Ukraine.

Read: Here’s the technology being used to watch Russian troops as Ukraine invasion fears linger

Fridson pegged energy as 15.4% of the U.S. BofA high yield index, making it “by a considerable margin, the biggest sector.”

From a high-yield bond perspective, U.S benchmark crude prices lately above $90 a barrel have been a bright spot. The American oil industry also has been demonstrating more financial prudence than in past boom cycles.

More important than the price of oil, according to Amundi’s Monaghan, is what companies are doing with the free cash they are generating.

“They are repaying debt,” he said. “For the energy exploration and production sector, it is no longer ‘drill baby drill.’ Companies have recognized that that they need to generate a return for stakeholders.”

That means both debt and equity investors, he said.

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