Riskiest US corporate debt finds favor with investors

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Investors are showing increased interest in the riskiest US corporate debt, as they become more optimistic about the state of the world’s largest economy. This is closing the gap between the highest and lowest tiers within the $1.35 trillion junk bond market.

The spread between double-B and triple-C bonds recently reached its narrowest level in 15 months at 6.53 percentage points before slightly widening to 6.74 percentage points at the end of the week. This indicates that investors are increasingly confident that the US can avoid a recession, despite the Federal Reserve’s multiple interest rate hikes since last year.

These hopes of a “soft landing” come after a series of positive economic data, including evidence of easing inflation and better-than-expected second-quarter growth figures in the US.

The narrowing gap between the top and bottom tiers of the junk bond market, which serves as an important indicator of investors’ risk appetite, represents a reversal from the aftermath of the failure of two US regional banks in March. This failure heightened fears of a recession and put pressure on bonds issued by highly-indebted companies. In April, the spread between double-B and triple-C bonds widened to 8.52 percentage points as investors avoided debt from companies at higher risk of default during an economic downturn.

“It’s been a few months since the First Republic bank failure”, said Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, referring to another collapse in May. Fridson also added that many investors believe that the Federal Reserve has completed its interest rate hikes. Despite lacking a clear message from Fed Chair Jay Powell, investors are holding onto this idea.

Yields and spreads on junk bonds still remain significantly higher and wider compared to their lows in 2021 when there was ample Fed stimulus in the financial system. According to investors, valuations this year have also been supported by a smaller market, with upgrades to investment-grade status and relatively low new issuances keeping prices at artificially high levels.

“We are still far from where we were at the beginning of 2022,” said Andzrej Skiba, head of Bluebay US fixed income at RBC GAM, referring to the period just before the Fed began tightening monetary policy.

Skiba further noted that he is cautious about adding exposure to triple-C rated issuers. However, he recognizes that other managers might be tempted to invest in lower-rated assets when the market conditions are favorable.