Junk-Bond Yields Show U.S. Can Handle Tightening

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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Since the beginning of June, bonds with lower credit ratings have done better than ones with higher ratings. This supports the view that interest rates are rising because the U.S. economy's prospects are improving. While those who worry that the Federal Reserve might endanger a fragile economic recovery may yet be proven right, the evidence is leaning toward the cautious optimists -- so far.

IBoxx $ Liquid High Yield Total Return Index (white line) vs. iBoxx USD Treasuries Total Return Index.

For starters, recognize that bonds issued by riskier borrowers generally pay higher coupons than bonds issued by the U.S. government. That means someone who lends to a shaky company for 10 years will get paid back more quickly (if she gets repaid at all) than someone who lends to the Treasury for 10 years. This tends to make lower-grade bond prices relatively less sensitive to changes in interest rates. In Wall Street lingo, Treasury bonds have a longer duration.

On Friday, Bloomberg Newsreported that bonds sold by AA-rated companies were now yielding less than bonds sold by AAA-rated firms. According to the article, traders are attracted to the fact that the average duration of AA-rated bonds (6.16 years) is shorter than the average duration of AAA-rated bonds (8.1 years). Meanwhile, the Financial Times reports today that investors are putting more money into the lowest-rated bonds precisely because they want to take advantage of those bonds' shorter duration.

However, the relatively shorter duration of junk bonds isn't enough to explain their out-performance. Suppose that rates on U.S. Treasury bonds were going up because traders were worried that the Fed would tighten policy while the economy still is weak. That would increase the odds of a recession. Since the weakest firms do worst during slumps, traders would be right to become more concerned about defaults from the dodgiest companies. Yet the interest rates on junk bonds are lower now than they were when the Fed met on June 19.

Barclays U.S. Corporate High Yield Yield to Worst

This is all the more remarkable considering that the yields on benchmark Treasury bonds have increased by about 0.65 percentage points since then. This is borne out by the collapsing spread between junk and high-grade fixed income.

BarCap U.S. Corporate High Yield Yield to Worst minus 10yr Treasury Spread

The performance of junk bonds doesn't necessarily end the debate about whether the Fed will tighten before the economy can handle it. However, it does suggest that many traders and investors are more confident that the economy can handle it when the Fed takes away the punchbowl.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.