Analysis: Investors Brace For More Weakness In U.S. Corporate Debt – Reuters

Federal Reserve Chair Jerome Powell is seen delivering remarks on a screen as a trader works on the trading floor at the New York Stock Exchange (NYSE) in Manhattan, New York City, U.S., December 15, 2021. REUTERS/Andrew Kelly

NEW YORK, Feb 8 (Reuters) – Investors are preparing for more downside in U.S. credit markets, as bets that the Federal Reserve will become more aggressive than previously expected threaten to further drive up yields and pressure prices.

After a comparatively placid January, corporate debt has started this month with sharp losses. The Markit CDX North American Investment Grade Index , a basket of credit default swaps that serves as a gauge of credit risk, recently stood at around 65 basis points after widening to its biggest spread since October 2020 on Friday following strong U.S. jobs numbers that sent government bond yields soaring to their highest level in more than two years.

Market participants worry there may be more downside ahead if Treasury yields, which affect rates across other asset classes, continue rising. The yield on 10-year Treasury notes was recently at around 1.92% after reaching a high of 1.936% on Friday, its highest level since Jan. 2, 2020.

“There’s nothing to stop the Fed from lifting rates now, and they’re going to do it probably every quarter this year … so when that happens, credit needs repricing,” said Ryan O’Malley, fixed income portfolio manager at Sage Advisory. “I think this has just begun.”

O’Malley said he was avoiding some new debt issues in the primary market, even if attractive, believing their prices will fall to give him a better entry point.

BlackRock’s iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD.P) – a major exchange-traded fund tracking the U.S. investment-grade corporate bond market – is already down nearly 2% to $125.3 since the beginning of February, after a 3.6% drop in Jan. Its high-yield equivalent has fallen 1.3% since the beginning of February after falling 2.6% in the first month this year.

Steven Schweitzer, senior fixed income portfolio manager with the Swarthmore Group, is beefing up exposure to floating rate notes, expecting their coupon to rise along with the Fed funds rates as the central bank tightens monetary policy.

BlackRock’s iShares $ Floating Rate Bond UCITS ETF (ISFLOT.L), which gives investors exposure to U.S. dollar-denominated floating rate bonds, is up 0.2% year-to-date, as investors factored in up to seven Fed rate hikes in 2022.

“That’s a pretty consistent theme that we’re spending a bunch of time on, and investing in,” Schweitzer said.

U.S. consumer price data, due out Thursday, could give investors more reason to get defensive on their bond portfolios if inflation proves stronger than expected. Consumer prices rose to their highest level in nearly four decades in December, reinforcing the case for a more aggressive Fed.

To counter the recent volatility, some investors have pulled back on riskier credit, as risk premiums – or what investors demand to hold corporate bonds rather than government-backed Treasuries – tend to widen when rates rise.

Others, however, have done so only gradually, uncertain about how far the Fed is ready to go in tightening monetary policy as it attempts to quell inflation without hurting economic growth.

Eric Gold, senior portfolio manager of high yield and head of the global credit team at MacKay Shields, has trimmed his allocation in triple-B and double-B credit, though he remains invested in the asset class on expectations that economic conditions should remain supportive for medium-to-high risk corporates.

“While we are pulling back on the risk, we’re not underweighting that risk,” he said.

For the time being, most investors agree that the price swings are here to stay.

In a Monday note, analysts at BlackRock Investment Institute said they expected a “benign” outcome from central bank rate hikes for broader markets, but warned investors to “brace for volatility along the way.”

“Volatility will continue to pervade the financial system until at least a couple more months of inflation, employment and geopolitical weather reports have been recorded and analyzed,” Rick Rieder, BlackRock’s chief investment officer of Global Fixed Income, wrote last week.

Reporting by Davide Barbuscia in New York Editing by Ira Iosebashvili and Matthew Lewis

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