Corporate bond funds succumbed to rate fears that have gripped stocks to Treasuries.
Investors pulled $14.1 billion from debt funds, the fifth-largest stretch of redemptions in the week through Feb. 14, according to a Bank of America Merrill Lynch report, citing EPFR data. High-yield bonds lost $10.9 billion alone, the second highest outflow on record. As benchmark Treasury yields traded at a four-year high, it shook the foundations of a key support for risk assets — low rates.
“Investors don’t sell their cash bonds in a big way until they are forced to, which happens when the outflows start picking up more sustainably,” Morgan Stanley strategists led by Adam Richmond wrote in a recent note to clients.
(Related: Untimely Fiscal Stimulus Is a Bond Nightmare)
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Creeping corporate leverage is setting the stage for a broader market meltdown while higher real rates drive down asset values, according to Morgan Stanley strategists, who project negative returns for corporate bonds in the U.S., Europe and Asia in 2018. They warned that leveraged companies would struggle to refinance as central banks tighten credit conditions and ‘tourist’ investors who’d dabbled in riskier debt lose interest as rates normalize.
“It’s a wake-up call that central banks are withdrawing liquidity, and that the process is not going to be smooth,” Morgan Stanley strategist wrote.
The iShares iBoxx $ Investment Grade Corporate Bond exchange-traded fund posted a record one-day outflow Wednesday, the most among U.S.-listed passive vehicles across asset classes.
While the dislocations sidelined some speculative-grade borrowers in Europe, others including German hire car firm Sixt SE returned to the primary market, while U.S. investment-grade activity carried on. That’s while risk premiums on high-yield U.S. bonds narrowed 10 basis points Thursday to 346, according to a Bloomberg Barclays index.
Long-term investors including Federated Investors Inc. and Axa IM expect credit to hold its own even as real rates climb, thanks to an upswing in economic growth and corporate profitability.
“Given the strength of underlying business fundamentals, we think high-yield spreads will tighten,” said Gene Neavin, manager of the $1 billion Federated High Yield Trust. “As long as the economy is well, we’ll do well.”
Strategists at Axa IM forecast the impact of a 1 percentage point increase in U.S. Treasury real rates would cause a modest 15 basis point widening for investment-grade bond spreads and 18 basis points for lower-grade debt.