High-Yield Debt Balancing Hawkish Fed With Regional Dynamics: Analysis

Photographer: Simon Dawson/Bloomberg

High-yield corporate debt markets remain susceptible to weakness and repricing risks after the latest Federal Open Market Committee meeting minutes suggested that a June U.S. interest rate increase is possible, Bloomberg strategist Simon Ballard writes.

Narrowing option-adjusted spreads indicate that the current tight level of sub-investment grade corporate bond spreads in the U.S. dollar, Euro and Sterling corporate bond markets has yet to reflect rate increase risks.

The more hawkish rhetoric received from the FOMC minutes on Wednesday may now trigger a degree of risk-appetite consolidation, even as investors continue to differentiate between dollar, euro and sterling risk.

The Federal Reserve said that it remains data-dependent in its monetary policy decision making, but any consequent rise in the underlying U.S. treasury yield structure, may carry with it both U.S. domestic and global ramifications. Certainly, it appears that no one has conveyed the embedded risk of a higher yield structure to the U.S. corporate high-yield bond market.

Notwithstanding the latest back-up in government bond yields in the wake of April’s FOMC minutes and the modest widening impact that this might have on risk assets in coming days, the dollar-denominated corporate credit curve is still some 180 basis points flatter year-to-date. In what is widely expected to remain an historically low yield environment, investors continue to chase yield.

Meanwhile, although never immune to gyrations in U.S. monetary policy, the Euro- and Pound sterling-denominated corporate bond markets currently appear to be pricing themselves off a different set of risk-reward dynamics.

Option-adjusted spreads on Euro-denominated high-yield bonds relative to those on investment-grade notes have narrowed alongside their dollar counterparts in recent months. But recently it is the prospect of investment grade, non-financial corporate bond purchases by the European Central Bank, as part of its Corporate Sector Purchase Programme, which has fuelled Euro credit spread performance. Hawkish rhetoric from the Fed may erode some of this risk appetite, but the strength of demand/supply dynamics within the borders of the euro area itself should help to underpin Euro credit spreads.

The Sterling credit curve has been the laggard of the three currency sectors as uncertainty over the June 23 EU referendum vote appears to have damped risk appetite and stalled a flattening of the Sterling corporate credit curve over the past three months.

Fed's global reach balances regional dynamics

Higher U.S. interest rates predicated on improving domestic macro data could be positive for credit fundamentals, but the pace and magnitude of any monetary tightening will likely be critical to how risk assets respond. Steady economic growth and a measured pace of tightening - a Goldilocks scenario - would be the optimal outcome for risk assets.

Conversely, a sharply higher yield structure would likely prove negative for U.S. high-yield notes. The implied higher debt-funding costs would be increasingly onerous for weaker-rated, lower-quality borrowers.

Meanwhile, the European credit investor base generally perceives that the Euro-denominated corporate bond universe will continue to benefit from robust demand-supply dynamics over the coming quarter as the European Central Bank commences the CSPP and effectively becomes the new marginal buyer of Euro-denominated non-financial corporate credit.

Near-term risks facing the U.K. corporate bond market continue to center on the June 23 vote. Perhaps more important than a potential U.S. interest rate increase, a vote by the U.K. electorate to leave the EU would likely trigger an immediate spike in financial market volatility and risk aversion, resulting in wider credit spreads and a re-steepening of the sterling credit quality curve. Conversely, a vote to remain in the EU may trigger a relief rally in U.K. risk assets and the currency. The latter scenario may see the Sterling credit quality curve flatten more sharply and play catch-up with the recent flattening moves seen in the dollar and euro credit curves.

Note: Simon Ballard is a credit strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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