Junk Bonds Slump as Morgan Stanley Sees Bigger Unwind Ahead

In 2014, insurers had about $200 billion in high-yield bond assets

The Federal Reserve Board wants to back away from the quantitative easing strategy. (Photo: Thinkstock) The Federal Reserve Board wants to back away from the quantitative easing strategy. (Photo: Thinkstock)

It could be the beginning of the end for an 18-month rally in junk bonds.

Investors demanded the most extra yield in almost a month to buy speculative-grade debt on Thursday, a day after Morgan Stanley warned a correction may already be under way. The cost of protecting high-yield bonds against default in the credit-default swap market climbed to its highest level since mid-July, while a junk-bond fund run by BlackRock Inc. slumped to a three-month low.

Morgan Stanley added its voice to a growing chorus of skepticism surrounding debt valuations, with Pacific Investment Management Co. writing in a report released the same day that investors should pare relatively expensive assets like corporate bonds in favor of safer investments like Treasuries. T. Rowe Price Group Inc. echoed that view, saying “everything is expensive.”

“This softness has a good chance of turning into a legitimate correction,” Morgan Stanley strategists led by Adam Richmond wrote in their note. “Complacency is too elevated.”

(Related: Tidal Wave of Insurance Cash Pointed Toward Junk Bonds)

Buyers of speculative-grade debt underestimate how much pressure the U.S. central bank will put on the securities by removing the monetary stimulus known as quantitative easing, the analysts wrote.

Junk-bond investors now receive an average of about 3.7 percentage points more yield than Treasuries, up 0.16 percentage point since Friday and heading toward the biggest weekly increase since April, according to Bloomberg Barclays index data. That’s still well below the average for the last five years of 4.7 percentage points.

In 2016, analysts at the National Association of Insurance Commissioners estimated that U.S. insurers had about $200 billion invested in bonds from issuers with weak credit ratings, and that investments in those bonds accounted for 5.6% of insurers' 2014 bond investments.

PetSmart Drops

An index of credit-default swaps on 100 non-investment-grade entities jumped to 339 basis points as of 11 a.m. in New York, on track for the highest closing level since July 11. The iShares iBoxx $ High Yield Corporate Bond fund, the largest exchange-traded fund focused on junk debt, fell a fourth day. Investors pulled almost $200 million from the $19.2 billion fund on Wednesday.

PetSmart Inc. high-yield bonds with an 8.9% coupon maturing in 2025 that were issued just a few months ago fell 3 cents on the dollar to 88 cents, their lowest-ever price, after the pet-store chain’s chief executive stepped down, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

There are still some signs of strong demand in the junk bond market. Tesla Inc. is selling $1.5 billion of speculative-grade bonds maturing in eight years. The notes will probably yield somewhere around 5.25%, lower than the average for similarly rated securities, even though Tesla’s operations generated negative cash flow for nine of the last 10 years, according to data compiled by Bloomberg.

But the high-yield debt market is underestimating the headwind from the end of quantitative easing, especially when the Fed is also increasing interest rates, the Morgan Stanley strategists wrote. The Federal Reserve said in July that it plans “relatively soon” to reduce stimulus in part by allowing its portfolio of Treasuries and mortgage bonds to start running off.

Investors should consider betting against the high-yield bond market using total return swaps, which remains “our favorite short,” the strategists said.

--- Read Junk Seen Enticing Yield-Hungry Insurers As Capital Rules Shifton ThinkAdvisor.

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