Valuation Angst Is Being Stoked by Fed’s Big Cut: Credit Weekly

(Bloomberg) -- Investors are pouring money into corporate bonds, risk premiums are grinding tighter, and the Federal Reserve’s interest rate cut is reigniting hopes the US will dodge a recession. 

Some money managers say the market is too complacent about causes for concern now. 

“You have the US election coming up, and expectations around economic growth in Germany are some of the weakest it’s been since pre-Covid times,” said Simon Matthews, a senior portfolio manager at Neuberger Berman. “Consumers are feeling the pinch and growth in China is slowing. When you pull that all together, it’s not telling you that credit spreads should be close to the tights,” he added, noting that falling borrowing costs will help reduce some of the headwinds. 

Investors have been setting aside the potential negatives and diving deeper into the riskiest corners of credit in the hunt for higher yields. The lowest-rated bonds are now outperforming the broader junk bond market while demand for Additional Tier 1 bonds, which can force losses on investors to help a bank survive turmoil, is expected to increase. 

Buyers are betting that lower borrowing costs will enable debt-laden companies to refinance and push out their maturities, limiting defaults and supporting valuations. And as short-term rates drop, investors are expected to shift their allocations into medium- and longer-term corporate debt from money markets which could cause spreads to tighten even further.

Still, inflation could start ticking up again if consumers start spending more as interest rates are cut, according to Hunter Hayes, chief investment officer at Intrepid Capital Management Inc.

“Who knows, maybe the Fed funds rate has to come right back up like it has in previous inflationary cycles and then, all of a sudden, high-yield bonds are a lot less attractive again,” he said. 

With US monetary policy likely to remain restrictive, market participants are also watching for signs of deterioration in fundamentals, especially among borrowers exposed to floating-rate debt, BlackRock Inc. researchers Amanda Lynam and Dominique Bly wrote in a note. In addition, issuers rated CCC remain pressured in aggregate, despite the recent outperformance of their debt, they wrote. 

They cited low levels of earnings the companies have in aggregate compared with their interest expense. Borrowing costs for CCC rated firms are still around 10% — crippling for some small companies when they have to refinance following the end of the easy money era — and leaving them at risk of default even as rates fall.

Any weakness in the labor market would also “be a headwind for spreads as it will increase recession fears and lower yields,” JPMorgan Chase & Co. analysts including Eric Beinstein and Nathaniel Rosenbaum wrote in a research note this past week.

To be sure, valuation concerns remain modest and investors are for the most part overweight corporate debt. The beginning of the rate-cutting cycle should also support demand for non-cyclicals over cyclicals in the investment-grade market, analysts at BNP Paribas SA wrote in a note. 

In particular, limited issuance by health care firms and utilities provide room for spread compression, they added.

“It’s a prime opportunity for non-cyclicals to outperform,” Meghan Robson, the bank’s head of US credit strategy, said in an interview. “Cyclicals we think are overvalued.” 

Week in Review

On the Move

--With assistance from Dan Wilchins and James Crombie.

More stories like this are available on bloomberg.com

©2024 Bloomberg L.P.