The US Junk Bond Market Contracts, Raising Concerns Over Economic Signals

The US junk bond market, valued at $1.35 trillion, has experienced a significant shrinkage of almost $200 billion since its peak in late 2021.

This decline is attributed to various factors, including rising interest rates, companies moving from the high-yield market to investment grade, and a shift towards private markets for funding. As a result, the total value of US junk bonds has decreased by 13% from its record high.

The reduction in available junk bonds has limited investor choices and led some fund managers to purchase bonds they may not have considered otherwise. This has contributed to the maintenance of higher prices for junk bonds, even as many anticipate an economic slowdown.

"Dramatically lower issuance" is seen as a key factor in supporting the valuations of junk bonds, according to Andrzej Skiba, the head of BlueBay US fixed income at RBC Global Asset Management. With cash accumulating every month, fund managers end up repeatedly buying the same bonds.

However, this situation has raised concerns that the current market conditions may give a falsely positive impression of the overall health of the US economy. Investors worry that the market's buoyancy may not reflect the underlying risks and could be vulnerable to a sharp decline if economic conditions worsen, especially for lower-rated companies that have not extended the maturity of their debt during the period of low interest rates.

While the reduced supply of junk bonds has helped maintain low spreads, some experts predict that volatility may increase and spreads may widen as recessionary pressures impact the market. As we approach year-end, concerns grow that the combination of economic headwinds and increased interest rates could lead to a change in market dynamics.

The US high-yield bond market has been a crucial financing option for risky borrowers over the years, but issuance slowed in 2022 and has only partially rebounded in 2023. The amount of money raised has increased by 30% compared to the previous year, driven primarily by refinancing activities. However, the number of new bond issuances in the first half of this year was the lowest since 1995, both in terms of deal count and dollar amount.

The decline in the high-yield market's size has been accompanied by a rise in bond yields. Junk bond yields have increased to 8.69% as of July 11 from a low of 4.53% during the Covid-19 crisis. The spread, which represents the extra yield demanded by investors to hold risky bonds over US Treasuries, has also widened to 4.05 percentage points. However, despite these increases, spreads remain narrower than historical averages.

The compression of the high-yield market has been influenced by ratings upgrades, which have supported prices. Many companies have transitioned to investment-grade status, while downgrades to junk have been limited. The year 2023 has already seen more than $81 billion of debt achieving investment-grade status. Further upgrades are expected, including companies like Mattel, Netflix, Occidental Petroleum, and Enact.

The decline in the junk bond market mirrors a contraction in the junk loan market, which has occurred for only the second time since 2010. Private credit markets have been a primary driver of this shift, attracting borrowers away from public debt. The private credit market has grown significantly, offering more certainty and involving fewer lenders.

As the US junk bond market continues to shrink, investors and market participants remain cautious about the potential distortion of economic signals and the vulnerability of the market to a downturn. The ongoing dynamics and challenges in the bond market highlight the need for careful monitoring and adaptation to evolving market conditions.

By fLEXI tEAM