Debt markets priced for perfection risk a stumble

“You only need a smaller percentage to come out and that will be sufficient as people have a fear of missing out of the yields in bonds. Spreads can probably get tighter than you would ever imagine because of the weight of money being invested.” Richard Hodges

NEW YORK: Investors flush with cash are embracing credit, moving up the risk curve in the rush to lock in high yields before the Federal Reserve (Fed) finally begins to cut interest rates.

Money is flowing into junk bonds again and high-grade funds just saw the largest weekly inflow since September 2020, according to Bank of America Corp.

That’s 19 weeks in a row that investment-grade products saw a net influx of money, strategists including Michael Hartnett wrote in a note.

The wave of new cash means bond managers are saying it would take a U-turn from the Fed on interest rate cuts to cause sentiment to turn negative.

Even if they aren’t fully comfortable with the reward for taking risk at the moment, there aren’t many other options than to trust that a rotation out of money funds and into debt could cause spreads to narrow even further.

“Price action is typical of the end of the bull run in credit markets,” said Jose Mosquera, chief investment officer at Madrid-based hedge fund Quadriga Rho Investments Multi-strategy in relation to pricing in Europe.

“Investors are moving further down the credit spectrum into less-frequent borrowers.”

At the moment, the biggest risk for credit “is that the Fed and all other central banks walk back totally the interest rate cuts that they’ve indicated to us already,” said

Richard Hodges, who manages the global dynamic bond fund at Nomura Asset Management.

Traders have been paring their expectations for interest rate cuts by the Fed this year, as more US data releases show the continued resilience of the economy.

While chair Jerome Powell suggested last Thursday that the central bank is getting close to the confidence it needs to start lowering benchmarks, the pace and size remains uncertain.

Inflows into investment-grade debt are at their highest for the start of a year since just before the pandemic, helping to drive spreads narrower.

A small rotation out of money market funds, which currently hold more than US$6 trillion, and into credit would drive those tighter still, according to Hodges.

“You only need a smaller percentage to come out and that will be sufficient as people have a fear of missing out of the yields in bonds,” he said.

He added that “spreads can probably get tighter than you would ever imagine” because of the weight of money being invested.

Sales of junior-ranking debt from European peripheral nations this week offered ample evidence of the reach for returns. Investors placed orders that were more than three times the 250mil (Us$272mil) of junk-rated tier-two bonds issued by Portugal’s Banco Montepio.

The securities paid a yield above 8.5%. This amounted to almost double the average yield of the bonds included in a Bloomberg index grouping such kind of notes.

Italian lender Banca Popolare di Sondrio received orders for more than five times the amount on offer in a similar sale, according to people with knowledge of the matter.

The extra yield offered to buy junk-rated debt tightened in recent weeks.

This was some of the lowest levels since early 2022.

That was before Russia invaded Ukraine and before the Fed and the European Central Bank started their interest rate hikes.

Yields for the riskiest part of the market, CCCS, fell below 12% this week in the United States for the first time this year.

Even troubled debt is benefiting from the broad-based rally, with the amount of distressed corporate bonds and loans dropping more than 7% globally since early January.

In the United States, it has fallen almost 10% in the same period to below Us$198bil.