Does the US junk bond market give us a glimpse of future UK trends?

Cast into the shadow for many years, the junk bond market is grabbing the headlines in the US, something which is likely to be replicated in the UK and globally. Asset management is a critical element of any investment strategy, and locking into relatively high yields can provide steady cash flow. However, there are several anomalies in the junk bond market, issues to be aware of and factors to consider.

 

Appetite for riskier investments continues to grow

 

Ironically, as the US Fed is now hinting at further interest rate rises to control a relatively strong economy, this has prompted renewed interest in high-yield bonds. While many would have expected the premium between Treasury yields and junk bonds to increase, in light of near-certain further interest rate rises, this has not been the case. There are many factors to consider, such as:-

 

Maturity

 

Once you begin to dig a little deeper, you will notice that the maturity on high-yield bonds is now less than five years compared to 8 years for the average investment-grade bond. This is a positive for junk bonds because it reduces an element of uncertainty concerning the future. While this trend was a response to forecast short term increases in US base rates, many expected rates to have peaked by now.

 

Supply and demand

 

Supply and demand are critical factors in asset management, whether bonds, equities or any other investment vehicle. What we have noticed with US junk bonds in recent years is a lack of new issues.

 

For example, over the last decade, the average value of new high-yield bond issues has been $284 billion a year. Last year, there were only $102 billion of new issues, and while the figure has increased to $130 billion so far this year, it is still well below the average. Consequently, those looking at high-yield assets are limited in choice, which is pushing prices higher and yields lower.

 

Is it time to look at a contrarian approach?

 

Some experts believe that demand for US junk bonds is overextending prices and reducing yields to levels which do not represent the risk/reward ratio. They have highlighted some issues, such as:-

 

Premium over Treasuries

 

Considering the premium to Treasuries is now less than four percentage points, this would suggest a strong economy and further strength to come. This compares to an average of 4.58 percentage points over the last 25 years and a peak early this year of 5.22 percentage points. At this moment in time, markets do not appear to be considering an increase in defaults.

 

Default rate expectations

 

While the junk bond market is currently focused on a relatively strong US economy, likely to keep short-term default rates low, the US Fed is determined to rein in growth. Akin to the sub-prime mortgage crash, where some investors simply ignored the signs, the storm clouds are starting to gather. S&P Global Ratings estimated default rates at 3.2% in June and 3.5% in July, and they now stand at 3.7%. This is expected to increase to 4.5% in June 2024, although this appears to be a relatively modest forecast compared to the 5.5% expectation from Moody's for the end of 2023!

 

Switching to Treasuries

 

As US Treasury yields continue to rise, some who bought into the junk bond market relatively early appear to be considering a switch. A recent report suggested that more than 50% of US banks have tightened their access to credit for industrial and commercial loans. Historically, this would indicate a yield premium between Treasuries and junk bonds of between 6.53 and 10.96 percentage points. A long way from the current circa four percentage point premium!

 

Summary

 

The UK is in a similar situation to the US; the economy is still relatively strong, inflation is heading down but not necessarily under control, and further interest rate rises are looking likely. Therefore, an in-depth look at the US junk bond market could give us an insight into potential trends in the UK. While there are many technical factors to consider, such as yield premiums, maturity, supply and demand, etc, it all comes down to the risk/reward ratio.

 

As Treasury yields continue to suggest further interest rate rises, with the potential to tip the economy into recession, could this be the tipping point for the recent rally in junk bonds?

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