The cost of reducing exposure to the bonds of junk-rated European companies has risen in recent weeks and the sell-off on the bonds themselves is approaching. That is a sign that more trouble may lie ahead for owners of the securities. The iTraxx Europe crossover, Markit’s credit default swaps index, effectively calculates the cost of insuring against defaults on a basket of underlying high-yield bonds.
By Monday’s end, this had widened 130 basis points to 470 bps since end-March, when a recovery following an initial sell-off after the invasion of Ukraine began to reverse. It stands higher than a peak first encountered in the wake of Russia’s invasion of Ukraine.
The blowout has been less critical in the actual bonds. However, they are starting to keep up with spreads moving further than CDS on certain days. The spread on the ICE BofA euro high-yield index — effectively the risk premium asked for by investors to hold the debt – has increased 115 bps since end-March.
It went up above a peak seen in March on May 9, hitting 515 bps, with a close to 30 bps move twice that seen in CDS. Since credit default swaps are initially a hedging product, it is not uncommon for them to be affected more and quicker compared to the bonds, especially by unforeseen events such as the COVID-19 pandemic or war.
Azhar Husain, head of global credit at Royal London Asset Management stated:
“Normally when you see that sort of activity, it’s an unknown known, something happens you didn’t expect and that’s why crossover moves so much, whereas what’s happened in last few weeks there’s nothing there you wouldn’t have known. It tells you there is some real fear in the market, and in a way that’s more fear… than cash (bonds) tells you.”
Perhaps credit investors have a lot to be worried about. European Central Bank bond purchases, which prompted investors into junk-rated debt in a quest for yield, are expected to be finalized this quarter. Earnings at weaker companies could be crashed by a growth slowdown.
Multiple factors may have kept cash bond spreads in check. CDS are more liquid and therefore easier to trade. But, trading in high-yield debt often strengthens only when new investment flows or bonds hit the market.
Strangely, the opposite has happened, with the junk debt market successfully shuttered for over 20 weeks until late April and outflows slowing down.
Supply of debt has fallen steeply – BofA analysts think a 73% drop in issuance from last year indicates investors are finally receiving cash flow from the high-yield bond market. That diminishes the need to trade their holdings to fulfill potential fund redemptions.
Analysts make out the credit sell-off as mainly caused by a repricing of the interest rates outlook so much as major central banks led by the U.S. Federal Reserve stiffen monetary policy to curb surging inflation.
One sign is that high-yield and investment-grade bonds have delivered equal total losses, of about 9%, uncommon in a “bear market” where weaker companies would be expected to underperform, BofA notes.
JPMorgan predicts high yield spreads could extend to 525 bps by end of 2022, citing inflation, the Russia-Ukraine conflict, market volatility, and supply disruption from China’s COVID lockdowns.