Investors drawn to junk bonds on hopes of Fed rate cut


Investors are tiptoeing back into junk bonds, as expectations that the Federal Reserve will step in to cut interest rates and support financial markets have calmed concerns over slowing growth.

US high-yield bond funds took in $1.5bn for the week ending June 12, putting an end to a streak of outflows that began at the beginning of May, as renewed trade tensions sparked fears of slowing global growth, damping appetite for riskier corporate debt.

Since then, rising expectations that the Fed will start easing monetary policy — most likely starting next month — has sparked a renewed hunt for higher returns as safer, sovereign bond yields have fallen across the globe.

“You almost have to reason for money not to flow into credit, because by itself it has nowhere else to go,” said Oleg Melentyev, a strategist at Bank of America Merrill Lynch. “It just has to reach for yield.”

Attention will be keenly focused on next week’s Fed meeting, where investors will be listening for further hints about the path of monetary policy, but it is widely expected that they will have to wait until at least the next meeting in July before the central bank takes action.

Nonetheless, junk bonds have recovered from a dip in May caused by renewed trade tensions, with the ICE BofA high-yield bond index hitting a new record high this week and taking its gains this year to 9 per cent.

“There is an ongoing hunt for yield now things seem to have stabilised,” said John Dixon, a high-yield bond trader at Dinosaur Financial Group. “The economy may slow, which may result in a cut in rates, but it is not going to slow enough to cause serious problems for high yield.”

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He added: “It’s kind of an ideal world of slow growth and reduced rates. It’s a goldilocks situation for the high-yield market.”

Despite the boost in flows, some signs of caution lingering in the market, with triple-C rated bonds — one of the lowest rungs on the ratings ladder — underperforming higher-rated debt, indicating investors are still steering clear of the riskiest company bonds.

Some investors and analysts have also warned against optimism in corporate debt markets. Moody’s recently increased its forecast for the junk bond default rate for a second time this year, from 1.3 per cent to 2.4 per cent, and Bank of America argues even this may be overly optimistic.

Analysts have highlighted the divergence between equity markets recovering and corporate debt bouncing higher, even as sagging government bond yields have drifted lower, signalling darkening economic clouds on the horizon.

“To me that is a disconnect,” said Mr Melentyev. “This is not a cyclical turn, although there are risks on the horizon that could take us there.”



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