Junk bonds are 'flashing yellow.' Watch these warning signs

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Cracks are forming in the junk bond market as investors demand higher payouts for owning the market's riskiest debt. It isn't time to ditch high-yield bonds, but investors should pay attention to the warning signs.
High-yield bonds now yield 8.1%, up from 7.22% a month ago. The increase reflects a jump in yields across the curve as investors bake in more inflation from high energy prices and other pressures, including concern about the deficit — hitting nearly $2 trillion in the fiscal year that ended Sept. 30.
The high-yield market is also showing stress on the credit side with spreads recently widening to levels not seen since April, according to the Federal Reserve Bank of St. Louis. Credit spreads are the difference in yield between the bonds and Treasurys of similar maturities. Wider spreads mean investors are demanding higher yields for holding corporate debt, viewing it as riskier.
Spreads are at 315 basis points in the overall high-yield market, higher than a year ago but still below levels in March when they reached 346 bps. One basis point equals one one-hundredth of a percent, or 0.01%.
The high-yield market consists of bonds rated BB+ by S&P and Fitch and Ba1 and under by Moody's. The lowest-rated cohort, CCC and below, has seen the most movement with spreads climbing dramatically over the past year to roughly 1,250 bps.
'Flashing yellow'
Right now, the high-yield market is "flashing yellow" but is "far from red," said Michael Arone, chief investment strategist at State Street Investment Management.
It makes sense that investors are demanding more compensation for taking on additional credit risk as borrowing costs rise, he said.
Yields are elevated across the board with the 10-year Treasury reaching its highest level since 2002 earlier in the week.
"The bigger question is whether this is simply a repricing of interest rate risk, or the beginning of a more fundamental reassessment of credit quality," Arone said.
He's in a wait-and-see mode since earnings are still growing, interest-coverage ratios remain good, and while default rates have ticked up some, he believes it is not concerning.
That said, the starting point in spreads is likely weighing on investors' psyche, since they are still low by historical standards.
"There's a small margin of error here, which I also think raises the anxiety level," Arone explained. "The compensation that investors are receiving for taking on this credit risk isn't overwhelming relative to history, and therefore subtle changes in credit spreads can be concerning."
'Logical cracks'
While there may be concerns about part of the lower-rated market, the overall high-yield market is in good fundamental shape.
In fact, credit quality is at a record high, with BB bonds making up over 60% of the market compared with 38% prior to the global financial crisis, said Kelley Gerrity, a fixed income strategist at Morgan Stanley Investment Management.
"We've had higher-quality companies coming in, and with higher rates now, you also have more discipline from companies that are more indebted ... just because of the higher cost of capital, so that actually is creating a bit of a healthier picture as well," she said.
The lowest tier of high yield has always been more speculative, since the bonds have a higher default risk. Therefore, it's no surprise that they are the ones seeing the most widening in spreads, said Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research.
The overall move in high-yield spreads have been "orderly," he said. "Are there cracks forming? I think the cracks are logical cracks with the lowest-rated bonds and it's too early to say that it's spreading to the broad credit market."
In addition, fluctuations within the CCC-rated and lower spreads have been idiosyncratic, Gerrity added. Morgan Stanley recently broke down the spreads in the lowest cohort into two buckets: performing assets and non-performing assets, which are defined as spreads above 1,000 bps.
The non-performing spread to worst is 2,818 bps, while the performing bucket — the biggest piece of the CCC market — is 461 bps, she said.
"It is isolated," she said. "I'm not necessarily sure that that will go away anytime soon, but it doesn't tell the story of overall concern and flashing caution for credit markets right now."
For now, investors should remain selective within higher yield, Gerrity advised.
"We're looking for the best relative value opportunities, and we think that exists within that single-B cohort, and so we're leaning into that," she said.
Warning signs
Investors should be concerned if there is a steep widening in the broader high-yield market.
But there's scant evidence of stress in the BB cohort. Spreads in that group are at 194 bps, up from 179 bps a year ago — although the move hasn't been in a straight line.
"We're going to be focusing our attention on what are considered some stronger businesses," Martin said. "If we start to see the markets demand higher spreads there also, that's what we'll be looking at to see if risks are really rising."
It's also important to understand that the Federal Reserve is raising rates in a strong economic environment, said R.J. Gallo, chief investment officer of global fixed income at Federated Hermes. The central bank is concerned about an inflation problem amid high fossil fuel prices due to the Iran war, while growth has been stronger than expected, he noted.
"With growth being good as the reason that the Fed is hiking, then you wouldn't expect high yield to blow out because growth means revenues stay up, means cash flow and profitability stays up," he explained.
High yield becomes a disaster when the economy is heading into a sharp economic downturn, Gallo said.
"That's when spreads really widen out," he said. "But a recession is not the odds-on bet. Now, talk to me in six months if the Fed keeps hiking over and over, if oil prices stay high for longer, well, then maybe we will start to wonder."

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