When economic growth booms, Treasury yields often rise and the prospects for junk bond issuers tends to improve. In an environment where interest rates are rising because economic growth is strong, junk bonds tend to outperform Treasuries. Spreads (difference in yields) on junk bonds narrow as the risk of default falls in a better economy
Don’t tell that to the crowd who has been reaching for yield in junk bonds though. As the FT reports, high-yield debt redemptions reached their second-largest net outflow, $10.9 billion last week. Central banks have distorted risk free yields for so long that many investors felt compelled to reach for income in the riskiest parts of the bond market.
With U.S. yields now rising, that trade appears to be unwinding.
The withdrawals came as market sentiment shifted this month, with investors growing nervous over signs of inflation that could prompt the US Federal Reserve to raise interest rates more aggressively than expected. The change in market mood has sent yields on benchmark 10-year US Treasuries to a four-year high above 2.9 per cent and the S&P 500 tumbling from its January peak.
“For those who do look at their high-yield allocation as return-seeking as opposed to a risk-mitigating asset, they probably are saying if the equity market is now turbulent I have to reduce return-seeking risk,” said Doug Peebles, chief investment officer of fixed income at AllianceBernstein.
Highly leveraged companies are being jostled by the pressure they may face from having to refinance their debt at higher interest rates, and the positive effect that faster economic growth may have on their businesses and ability to pay off debt.
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Jeremy Jones, CFA
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