In the first six months of 2023, CCC-rated junk bonds have been outperforming investment-grade corporate bonds (AA-rated) by a fairly wide margin. Junk bonds are up 10% year-to-date, compared to 2.7% for highly-rated bonds.1
One viable reason for the outperformance has been the U.S. economy’s resilience so far this year. Borrowers with weaker balance sheets are benefiting from the absence of a recession, which has given investors the ability to benefit from higher yields and a lower risk of default. It’s also meant that many upstart and ‘growth’ companies have been able to grow and service their existing debt without having to borrow more or refinance, which is crucial—especially since many of these less-creditworthy companies continue to benefit from low borrowing costs locked in during the era of near-zero interest rates.
But these favorable conditions may be changing soon.
For one, the Federal Reserve’s policy stance has shifted over the past few months. In March, a majority of Fed officials had projected that no additional rate increases would be needed in 2023. But stubborn inflation and ongoing strength in the economy and labor markets have shifted their thinking.
Consumer prices, as measured by the Fed’s preferred personal-consumption expenditures (PCE) price index, rose at a seasonally adjusted 3.8% annual rate in May, a meaningful improvement from the 7% peak rate reached in July 2022 but still well above the 2% target. Core prices, which exclude food and energy, registered at 4.6% in May, a slight improvement from April’s 4.7% print but again well above what the Fed wants.
PCE Price Index (Blue) and Core PCE Price Index (Red)
Source: Federal Reserve Bank of St. Louis2
Still elevated inflation continues to be pressured by the services sector, namely in housing where the impact of rising and falling rents work on a lag. Regardless of the cause, the Federal Reserve has responded by signaling that more hikes are likely in 2023. At the June meeting, the Fed released projections for the Fed funds rate for the remainder of 2023, and 12 of 18 officials indicated that rates would need to rise from 5.5% to 5.75% or even higher. These projections imply two or three more rate hikes in 2023, which is higher than just about anyone had expected for the year.
And that’s not good for the riskiest segments of corporate bond markets, in my view. Weak borrowers that were able to take advantage of ultralow interest rates are likely to encounter much higher rates when it comes time to refinance, which many will need to do. There appears to be some passivity to this issue in debt markets at the moment, mainly because most of the currently outstanding corporate bonds don’t start maturing until 2025 – which means there’s time for the Fed to shift its stance to cutting rates.
For its part, the market continues to price in the likelihood of recession, which means it’s also pricing in rate cuts sometime in the next year. Perhaps that’s why we haven’t seen much pressure in junk bond markets to date.
But as readers know, I think there is a distinct possibility the U.S. could avoid recession altogether, which would certainly complicate the interest rate picture for risky borrowers. If the Fed keeps rates “higher for longer” as a result of continued economic growth, refinancing will remain expensive. That’s not good for companies with weak free cash flow and high debt loads.
Bottom Line for Investors
Given recent outperformance in junk bonds, there appears to be some level of complacency when it comes to the outlook for interest rates, i.e., that they are set to fall in the next year or so.
But I would caution against that conclusion. If the U.S. economy continues to be resilient – which I see as a distinct possibility – it could mean ‘higher for longer’ interest rates, which I think would factor as a negative surprise for companies expecting a lower cost of borrowing and refinancing relative to where rates are today. For investors venturing out onto the risk curve of corporate debt, I think that means being very cautious around the riskier borrowers.
Disclosure
1 Wall Street Journal. July 5, 2023. https://www.wsj.com/articles/markets-ignore-the-looming-debt-peril-aac19b32
2 Fred Economic Data. June 30, 2023. https://fred.stlouisfed.org/series/PCEPI#
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