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.”
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.