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Market Extra: This segment of the corporate bond market is flashing a warning that investors shouldn’t ignore

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U.S. stocks just cemented their worst start to a year in more than half a century. But as the slowdown in the U.S. economy becomes increasingly difficult to ignore, the market for high-yield corporate bonds — often referred to as “junk bonds,” a Wall Street sobriquet for the debt of companies with less-than-stellar credit ratings — is flashing a warning.

As of the close of markets on Thursday, the spread on the Bloomberg High-Yield Corporate Bond index — a measure of the risk premium being demanded by investors holding the bonds included in the index — had reached its widest level since July 2020. To be included in the index, companies must have a credit rating of “BB” or below from Moody’s Investors Service or S&P Global Ratings.

Even credits belonging to oil and gas companies, which have long made up a sizable chunk of the index (recently, they comprised about 15%) have been battered since the start of the year due to the Federal Reserve’s decision to raise its target for the fed-funds rate by 1.5 percentage points since it kicked off its rate-hiking cycle in March. While these credits have outperformed many of their peers from other sectors due to the surge in oil and gas prices, the surge in borrowing costs has still weighed on prices.

Ironically, the reason why high-yield bonds have sold off in recent days is the same reason why government bonds like U.S. Treasuries have rallied: Escalating recession fears are prompting investors to dump risky assets like junk debt and stocks in favor of “safe haven” assets like the U.S. dollar and government bonds.

“High-yield credit spreads are moving wider largely because the market has begun to fear that high inflation will force the Fed to tighten monetary policy even more aggressively, pushing the economy into a recession,” said Gennadiy Goldberg, a senior U.S. rates strategist at TD Securities.

“It’s the same reason that Treasury yields have declined in recent days as markets have begun to fear that very hawkish Fed rhetoric will indeed get inflation under control, but at the expense of economic growth,” Goldberg added.

On Thursday, investors were confronted with more signs of a slowing economy. A reading on consumer spending came in below economists’ expectations, while the Federal Reserve Bank of Atlanta’s latest estimate for second-quarter GDP growth came in at minus-1%. If that estimate proves correct, then it would mean the U.S. economy has already descended into a technical recession, which is defined as two consecutive quarters of economic contraction.

There’s a good reason why investors should be paying attention to high-yield credits now: High-yield credit spreads are considered by market specialists to be a leading indicator for the economy, since investors in these credits are especially sensitive to anything that could impair companies’ ability to repay their debts. High-yield bond ETFs have already seen their biggest outflows for the first half of a year on record, MarketWatch previously reported. Bond yields move inversely to prices, rising as prices fall.

“When you look at high-yield credit spreads, they do tend to be a leading indicator, especially of how investors are perceiving the economy. Investors are demanding a lot more yield, a lot more compensation, to invest in these bonds given the risks that are rising. There’s less faith today in the ability of these companies to remain current on their debt payments than there was just a few months ago,” said Collin Martin, a fixed-income strategist at the Schwab Center for Financial Research.

Another problem with rising yields is that they tend to be self-reinforcing: Rising yields increase the cost of refinancing a company’s debt, depriving companies of capital during difficult economic times, when they need it the most. As Charlie Bilello, founder and CEO of Compound Capital Advisors, pointed out in a tweet, high-yield credit spreads topped 10 percentage points during each of the past three recessions.

And rising credit spreads are also a problem for the underlying U.S. economy. Since this class of corporate borrowers employs millions of Americans, CEOs and CFOs typically respond to higher borrowing costs and other indications of a looming recession by laying off workers and delaying investments.

“If you’re a CEO or CFO, you’re looking forward to what your corporate profit outlook looks like, you’re seeing input costs rise, you’re seeing labor costs rise and you’re seeing borrowing costs rise, and given market expectations for slower growth you’re probably seeing demand for your product decline. So what do you do to successfully run your business? You don’t spend more on capex, you don’t go hiring more employees because you know your profits might stay flat or even shrink,” Martin said. “It’s a pretty negative outlook right now.”

The rise in spreads has yet to translate to higher defaults, but that could soon change. Both Moody’s and S&P, the two leading providers of credit ratings for corporations and governments, expect the default rate for high-yield borrowers to climb to 3% or more over the next 12 months, according to their projections.

And with the Fed expected to raise its fed-funds rate target by another 150 basis points or more before the end of the year (while continuing to shrink its balance sheet) companies will quickly find their borrowing costs rising dramatically — even doubling — within a year.

With inflation, labor costs and the cost of debt service all rising, management will likely be forced to countenance cutbacks like job cuts. Indeed, job cuts are part of the Federal Reserve’s plans for reining in inflation, since the central bank believes that a higher unemployment rate is necessary to combat inflation.

As Martin pointed out, higher borrowing costs won’t affect most “junk” borrowers until they need to refinance. But borrowers who rely heavily on floating-rate products like leveraged loans could see the shock of higher borrowing costs hit more quickly. Many corporations rely on both junk bonds and leveraged loans, and higher rates on these products could quickly have spillover effects for the stock market and the overall economy, Miller said.

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