The Daily Update - Pre-Crisis Junk Premiums Signals Caution

Today marks a new low, not just for Aston Martin share prices and US Presidents’ tax scandals, but also for speculative bond risk premiums. US junk bond spreads have fallen to their lowest level since before the global financial crisis. With US 10-year treasuries ebbing between 3.03% and 3.11% following the latest Fed rate hike and ongoing inflows more than filling the supply of sub-investment grade debt, yesterday the difference in yields reached its narrowest since July 2007.

Other factors pushing investors towards assets with more speculative fundamentals have of course been a hunt for yield and a series of generally solid quarterly earnings across US corporates. But in-line with their stocks, (so-called) high-yield bonds especially face the associative factors of earnings expectations sinking simultaneously with price-to-earnings multiples; for when markets reach a consensus that we are in the late stages of an economic cycle and both of these take a dive, companies’ leverage balloons while their ability to meet obligations vaporises. In a crisis, all this happens whilst lenders withdraw their funding and investors – finally fearful of losing capital – rush to surer grounds.

With this narrow junk premium being a familiar late-cycle signal, watching speculative bond and equity fund outflows, default rates and lending confidence in this sector becomes increasingly significant. Acceleration in any or all of these would give strong reinforcement to justify a flight-to-safety. But waiting for all the facts to be sure almost inevitably puts one behind the curve and we continue to remain convinced that higher quality credit and avoiding excessively indebted countries and corporations are already the more sensible investment foundation. In the right places, there are still pockets that offer attractive yield without the same breadth and magnitude of risk that we perceive in the largely expensive high-yield universe.

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