Weakness begins to show

“Companies with the weakest fundamentals often show problems first late in a cycle, and the retail sector has many such examples,” said Adam Richmond, Morgan Stanley’s chief credit strategist.

“Investors initially treat those issues as idiosyncratic, and then the problems spread, when credit conditions begin to tighten,” he said. “That is how the late cycle can transition to end of cycle.”

These risks are hard to see at the index level, with the Bloomberg Barclays U.S. high-yield benchmark up almost 7 percent this year, led by CCC-rated names. Still, the latter has underperformed the broader market over the past two months, suggesting investors are increasingly compelled to pricein deteriorating fundamentals — reminiscent of a market in its late winter, according to the U.S. lender.

Some 40 speculativegrade bonds denominated in the U.S. currency traded below 80 cents on the dollar — one rough rule of thumb to denote distressed junk names — at the close of trading Tuesday, compared with 23 obligations in early March, according to Bloomberg data.

“Dispersion in 2015 and 2016 was higher in-line with markets that were more volatile as well there being a strong sectoral component to the sell-off, i.e. commodity-sensitive sectors,” wrote Vishwas Patkar, credit analyst at the U.S. bank. “This time around, it is notable that we are seeing dispersion rise even though spread levels are very tight — and there isn’t really a one-sector story.”

Tighter financial conditions will eventually pave the way for higher defaults and wider spreads, suggesting investors should favor higher-quality companies, the bank concludes.

“The market is penalizing weak companies across different sectors,” Patkar added. “This is, we believe, yet another late-cycle indicator.”