Analysis: After weathering February storm, junk bonds count on Fed protection

(Reuters) – Junk bonds, the only fixed-income segment still offering positive returns this year, will continue their outperformance, according to investor bets the U.S. Federal Reserve will eventually put its foot down and calm bond markets.

FILE PHOTO: Trader Frank Masiello talks on his phone on Wall St. outside the New York Stock Exchange (NYSE) in New York, U.S., January 15, 2021. REUTERS/Brendan McDermid/File Photo

The sector, with credit scores below BBB-minus, is among the riskiest debt categories. But it weathered February’s market storm better than most, delivering year-to-date returns around 1%, BofA indexes show.. Sovereign and higher-grade corporate bonds are in the red.

To be sure, corporate debt may face bigger challenges in the coming months.

Last month’s bond selloff was fuelled by real Treasury yields climbing to multi-month highs. If that continues, with the rise in bond yields outpacing inflation expectations, this could spell danger as it represents a rise in the real cost of capital.

But if central banks keep real yields in check, rising bond yields driven by inflation expectations should support companies.

“High-yield (debt) is one of the few asset classes left which is giving you a positive return after inflation,” said Azhar Hussain, head of global credit at Royal London Asset Management.

“That is a reason why, if you want to shelter from an inflationary storm, high-yield is going to be the place to come and hide.”

A global BofA high-yield index currently yields around 4.4%. An index tracking investment-grade debt from major markets pays 0.9%.

On an inflation-adjusted basis, U.S. junk bonds yield 2%, compared with minus 0.1% on investment-grade peers and minus 0.7% on 10-year Treasuries.

The world’s largest asset manager, BlackRock, recently downgraded sovereign bonds but said it still likes high-yield.

Graphic: Only junk bonds left offering return in fixed income –

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The punt hinges on the Fed stamping on any significant increases in real yields.

The facade showed signs of cracking last Thursday, when 10-year Treasury yields rose past 1.60%, causing junk debt to suffer its worst day since November. Junk bonds sold off again this Thursday, when Fed Chairman Jerome Powell disappointed markets.

BlueBay Asset Management chief investment officer Mark Dowding says a swift rise in 10-year Treasury yields to 1.75% will trigger retrenchment.

John McClain, high-yield portfolio manager at Diamond Hill Capital Management, sees 2% as the pain point, expecting the bond market to “force action out of the Fed or the Treasury” before that.

Ten-year Treasuries at 2% would equate to a 0% real yield, ING Bank analysts calculate.

Deutsche Bank strategist Jim Reid is among those who believe corporate debt burdens will force central banks to act. A sustained jump in real yields may push up the premia paid by corporate bonds, something they are unlikely to allow.

Another layer of protection is the short-maturity/high-coupon structure of junk bonds, the so-called shorter duration, which makes them less immediately sensitive to changes in interest rates. This was one reason for the sector’s resilience last month.

The shorter the duration, the quicker investors recoup their initial investment in the bond through coupon payments. So in a selloff, the higher coupon payments that flow in buffer losses from the bond’s drop in price.

Average duration on the BofA U.S. high-yield index is around five years, compared with around seven for the U.S. Treasury index, according to Refinitiv Datastream.

“(Investors) have to look for a coupon income in order to face these rises in yields, because otherwise they would lose value. The only asset at the moment that can offer a buffer against these rising yields is junk,” said Althea Spinozzi, fixed income strategist at Saxo Bank.

The riskiest and highest-yielding junk segment, rated CCC and lower, delivered 4%-plus returns in both Europe and the United States this year, and outperformed during the market rout.

For junk to take a hit, shorter-dated borrowing rates would need to rise, Royal London’s Hussain notes. But those have been remarkably stable, with two-year Treasury borrowing costs unchanged this year, contrasting with steep rises at the longer end.

Graphic: Junk bonds vs. U.S. Treasuries –

Meanwhile, vaccinations and expectations that defaults will fall this year give investors greater comfort holding debt from COVID-exposed sectors. McClain, for example, says he has “pivoted aggressively to the more COVID-exposed sectors, things like travel, leisure and gaming”.

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