Junk bonds rally as investors speculate inflation has peaked

Yields on below-investment-grade corporate bonds tracked by Intercontinental Exchange’s index have declined to 8.76% through Monday’s trading, down from a recent high of 9.61% on Oct. 13. Investors say they are growing more confident that interest rates might peak without putting many lower-rated companies’ ability to repay debt in serious jeopardy.

Bonds across the board have been slammed this year by the Federal Reserve’s efforts to contain inflation, which has fueled the steepest series of interest-rate increases in decades. Inflation and higher rates undercut the value of bonds’ fixed stream of payments to investors, sending bond prices lower and yields higher.

Adding to the suffering for junk-rated bonds have been fears that higher rates could bring an economic slowdown that would hurt debt-laden businesses’ ability to make payments on time, raising the possibility of defaults.

In the past month, fresh data and comments from Fed officials have convinced many investors that the end of rate increases could be in sight. Figures showing that year-over-year inflation slowed to 7.7% in October from 8.2% in September, “were a welcome relief,” Dallas Fed President Lorie Logan said after their release.

At the central bank’s November meeting, officials “were increasingly focused on the question of when the Committee might slow the pace of future increases,” according to the meeting’s minutes, referring to the rate-setting Federal Open Market Committee.

Meanwhile, rising rates haven’t dimmed the outlook for corporate profitability as much as some investors had feared. While more companies are laying off workers and cutting their forward guidance as demand slows, Wall Street analysts still expect corporate earnings among S&P 500 companies to grow 6% this year and another 6% next year, according to FactSet.

“Despite the fact that we think we’re going into a recession in 2023, corporate balance sheets are in pretty good condition,” said John McClain, a portfolio manager at Brandywine Global Investment Management. “We don’t see a meaningful default cycle going into 2023 and beyond.”

Those factors have helped draw a steady stream of cash into junk-bond funds in the past month. Funds of sub-investment-grade debt have drawn positive net inflows for five straight weeks through Nov. 23, adding a total of $13.47 billion during that stretch, according to Refinitiv Lipper. That marks the largest sustained run of inflows this year by far.

More companies in addition are paying down debt, a positive signal for junk-bond investors who scrutinize balance sheets to determine how likely businesses are to pay back debt on time.

Last week the junk-rated clothing retailer Abercrombie & Fitch said it bought back $8 million of its own debt in the third quarter, alongside $8 million of share repurchases. In October, Joel Ackerman, chief financial officer of the dialysis provider DaVita Inc., told analysts on a conference call that the company would focus more of its capital deployment on lowering its debt level.

With higher financing costs putting corporate deal making and fundraising on hiatus, a dearth of new issuance has supported junk-bond prices this year. At barely more than $100 billion in 2022, junk-bond issuance is on track to fall by more than 78% compared with last year, according to Leveraged Commentary & Data.

Despite the recent rally, junk bonds have still handed investors losses on the year, returning minus 11% in 2022 including price changes and interest payments, according to ICE’s indexes. That is still better than the minus 15% returns on higher-rated corporate debt.

High-yield bonds have outperformed others largely because, in addition to offering higher interest payments, they tend to come due more quickly than their investment-grade counterparts, said Steven Foresti, chief investment officer for asset allocation and research at Wilshire Advisors. That means their prices are liable to fall less when interest rates rise.

Mr. Foresti has been telling clients that, at yields near 9%, junk bonds are offering attractive value. “There is much more utility to these investments than there was even less than a year ago,” he said.

Others are skeptical. In the midst of the recent rally, junk bonds are offering 4.63 percentage points more yield than Treasurys, down from nearly 6 percentage points in June. During past recessions, that premium, or spread, has often climbed above 8 percentage points as investors demand higher compensation for rising risk of default.

Now, with many investors confident that a recession is on the way, junk-bond spreads aren’t high enough to make the risks worthwhile for investors, said Saurabh Sud, a portfolio manager at T. Rowe Price.

Just as the Fed was late to respond to inflation’s rise in 2021, the central bank might be slow to ease off as the economy cools, he warned, a gloomy prospect for highly indebted companies.

“If that creates an environment where fiscal overtightening is high, what that implies is that the risk of an accident in credit is high,” Mr. Sud said.