Has the junk bond market bottomed out? Liquidity issues could be next, warns this industry veteran

Don’t call it a dash for the trash yet.

US corporate bonds with riskier high-yield or junk credit ratings could finally look like a buy, after a rough start to 2022 sparked by central bankers seeking to end an era of easy money.

Junk bond prices fell and yields hit two-year highs of around 7.5%, according to the ICE BofA US High Yield Index. This is probably a comfort to those waiting for the moss to leave the most speculative corners of the markets.

But Rajay Bagaria, chief investment officer at Wasserstein Debt Opportunities, still sees reasons why investors should remain cautious.

“There’s a scenario where everything seems pretty cheap right now,” Bagaria, a leveraged finance veteran, said by phone Friday. “There’s this possibility of a soft landing. And I think if that happens, you’ll look back and say, a lot of high yield stocks are down 15 to 20 points in four months. That’s not happening. not very often.

On the other hand, however, he thinks investors could downplay several key factors, including the effects of strong outflows this year (see chart), with high yield being the hardest hit in terms of outflows based on assets under management.

High yield has been the hardest hit this year based on assets under management

Goldman Sachs Investment Research, EPFR Global

There are also risks of continued interest rate volatility – a key driver of negative total returns in the first quarter – and investors taking “false comfort” in certain economic indicators, such as the roughly 10% drop in prices. copper HG00 relative to a pandemic peak, a popular predictor of economic activity.

Bagaria worries about a boom in China’s economy that could keep commodity prices, inflation and interest rates high as that country reopens from the latest COVID shutdowns

The key 10-year US Treasury yield TMUBMUSD10Y,
2.932%
reached a multi-year high of 3.12% in May, after a low of around 1.63% in January. Total returns for the high-yield index fell 10% on the year, according to BofA Global, and on pace with its second-worst annual loss on record, eclipsed only by its 26% loss in 2008.

Federal Reserve Chairman Jerome Powell said this week that the central bank’s plan to achieve a soft landing for the economy, while mitigating high inflation, was not entirely in his handsreferring to the geopolitical risks of war in Ukraine and COVID lockdowns in China, in an interview with Marketplace.

Bagaria sees a chance that the Fed will “induce a pretty hard recession”, if the central bank raises interest rates significantly in its quest for price stability. He also said cracks had already started to appear in high-yield debt, in the form of falling bond prices, following the release of disappointing results by several companies.

“Until the last week or two we felt like it was a normal, functioning market, the liquidity premium was still low,” Bagaria said. “You’re starting to see price discrepancies now, because people just want to release stuff.”

It’s not just the debt of once-in-vogue companies like Carvana Co. CVNA,
+2.43%
or Coinbase Global Inc. who took a beating.

To see: Carvana and Coinbase junk bonds tumble on Wednesday as layoffs and losses hit prices

Party City Holdco Inc.PRTY,
+6.06%
announced a shortfall this week, and its stock fell and its B-rated bonds due February 2026 fell to around $74 on Friday, from $96 in March, according to Bondcliq.

“The fact that you’re seeing a real high yield capitulation, in specific situations, suggests to us that liquidity is becoming the issue,” Bagaria said. “And when liquidity is the problem, everything is free.”

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