Corporate bonds have been relatively resilient amid a global government bond selloff, but the strength may not last.
Bond market volatility, a measure of uncertainty about the direction of bond yields, is spiking. Historically, that has foreshadowed trouble for corporate debt, as nervous retail investors and others pull money from the market.
For now, company profits are strong and higher overall corporate bond yields in part reflect solid economic growth. But, as inflationary pressure builds, the Federal Reserve is boosting rates to slow that growth. Over time, higher rates could hurt the economy and squeeze profits, and corporate bonds were already priced with little margin for error, said Kelly Kowalski, head of investment strategy at MassMutual.
“The longer yields are elevated and volatile, the more restrictive financial conditions become and the more they weigh on economic activity, corporate margins and credit quality,” Kowalski said.
The result may be that company bonds eventually underperform government debt, which would boost the extra yield relative to Treasuries that companies pay to borrow, a difference known as the spread.
JPMorgan Chase & Co strategists, including Nathaniel Rosenbaum, estimated this week that United States high-grade corporate bond spreads should be about a 0.07 percentage point wider than they are now based on historical measures of bond and stock market volatility.
Yields across bond markets have broadly jumped in the past month as oil prices have climbed and inflation fears have risen. Most benchmark US Treasuries now have yields above 5 per cent, with five-year yields climbing above that threshold for the first time since 2007.
Corporate bonds have largely shrugged off these moves. US high-grade spreads were 77 basis points on Thursday, two basis points tighter than their levels at the start of the month. Money managers looking to fund future liabilities, such as pensions and insurers that sell annuities, often buy corporate debt when yields rise, supporting relative performance for company bonds.
“There’s a lot of market experience with times where rates go up in a fairly controlled fashion because the economy is actually good, is doing well. And in those cases, the shocks tend to be fairly short-lived and moderate,” said Robert Tipp, head of global bonds and chief investment strategist at PGIM.
Even so, some investors are preparing for potential weakening. The ICE BofA US Bond Market Option Volatility Estimate Index, known as the MOVE index, surged to about 105 basis points this week, its highest level since March and far above its average of about 80 for the decade.
Those kinds of debt market volatility surges can be a prelude to corporate spreads rising, as in early 2023, when bond yields rose, as did the MOVE index. But the correlation isn’t perfect. And a separate measure of fear in US equity markets, the VIX, hasn’t jumped.
“Yield-oriented investors want higher yields, but they want stable, higher yields, and yields have been anything but stable,” said Tom Murphy, head of investment-grade credit at Columbia Threadneedle Investments.
The cost of protecting a portfolio of North American credits against default using credit derivatives has also edged higher recently, even accounting for changes to the constituents of the index, a sign that investors are getting a bit more antsy about default risk. The CDX Investment Grade Index was about 58 basis points on a roll-adjusted basis on Friday, compared with roughly 55 basis points at the end of August.