Concern that the recovery in developed economies may be faltering is driving bond spreads to levels not seen since the worst of the credit crunch.
Investors fear the divergence points to a longer-term trend. The bad news has focused on America, where home sales figures came in much weaker than expected. The US also suffered a sharp downward revision in GDP growth figures for the second quarter from 2.4 per cent to 1.6 per cent.
“Those statistics are bound to make people cautious,” says Allenbridge director of fund research and Adviser Fund Index panellist Jonathan Wallis. “We have been cautious on the prospects for equity markets for a while and high yield tends to be more correlated with them than investment-grade.”
The bond markets have responded quickly to this uncertainty, pushing the yield of government and investment grade debt to near record lows.
The yield on American investment grade bonds briefly reached 3.74 per cent on August 24, according to the Bank of America Merrill Lynch US Corporate Master index – the lowest figure recorded by the index since it was launched in October 1986.
Spreads on high-yield debt rose by eight basis points to 689 basis points and Bloomberg data showed no junk-rated debt has been sold since August 20. The size of the spreads, however, suggests to some advisers the market is becoming overly pessimistic unless default levels start to pick up. This has particular relevance to the inflation/deflation debate as an unexpected rise in inflation could force central banks to raise interest rates, which would batter bond prices.
“We favour high yield because the spreads are so high between them and treasuries and gilts that you are getting are protected against interest rate hikes,” says Whitechurch Securities head of research Ben Willis, “We have gone overweight in them relative to investment-grade.”
The problem facing investors in high-yield debt is that many of these companies have significant refinancing requirements over the next few years and, with banks and pension funds de-risking their balance sheets, many market-makers have been taken out of the equation. This has implications for the liquidity of risk assets, and companies already constrained by tight credit conditions must rely on a dwindling number of investors for financing.
Therefore, the flight to quality can increase the risk that companies will fail to find ready sources of capital to fund their debt and be forced into default. “There is still a risk of defaults but our job is to pick managers who we believe can avoid them,” Willis says. “At current yields, we feel we are being compensated for taking on those risks.”