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Yellen and the Fed fear corporate debt, but investors still aren’t

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Experts in corporate debt scaring policy like former Fed chairman Janet Yellen does not scare market participants too much.

In fact, some of them continue to take on debt from lower quality companies because they manage to outperform some of the investments considered safer.

“Attack is the best defense,” Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, told clients in a note stressing that BBB-rated companies outperform their A-rated counterparts. BBB is the bottom rung before the junk , and the increasing level of corporate bonds reaching this level is cause for concern.

Some investors worry that companies whose debt is at risk of sliding into high yield territory will find it difficult to meet their obligations in the next economic downturn.

But Mikkelsen thinks those concerns are misplaced.

The S&P 500 Triple-B Investment Grade Corporate Bond Index is down 2.9% year-to-date, which is not good. However, the group outperforms the broader S&P 500 / MarketAxess Investment Grade Corporate Bond index, which fell 3.5% in 2018.

Outperformance increases when isolating for risk-adjusted excess returns and works against history when credit spreads widen. Higher-grade bonds typically outperform in these cases, Mikkelsen noted.

“This outperformance of BBBs is remarkable as one of the [the] the main concerns for investors this year remain the possibility that large capital structures rated BBB will be downgraded to high yield in the next recession, ”Mikkelsen wrote. “We believe this outperformance partly reflects a low probability of a recession built into credit spreads, as well as the fact that most large BBBs are unlikely to be downgraded to [high-yield] as soon as they tend to have stable cash flow and significant financial flexibility. “

One of the reasons cited for the unexpected outperformance is that “the US economy is strong and credit fundamentals are improving” while negative technical signals are multiplying elsewhere.

Merrill Lynch recommends that investors use BBB debt as part of a “barbell” portfolio, combined with Treasuries, as a counterweight to safe but underperforming A-rated debt.

Yellen sees “a lot of bankruptcies”

Yellen, however, warned Monday that companies are taking on too much debt and could be in trouble if unexpected problems hit the economy or the markets.

“Corporate debt is now quite high and I think there is a danger that if there is something else causing a slowdown, these high levels of corporate debt could prolong the slowdown and lead to many bankruptcies in the non-financial business sector, “the former central bank chief said at an event at CUNY in New York.

Yellen also warned that the debt was held in instruments similar to those used to pool the subprime mortgages that led to the financial crisis ten years ago.

Indeed, corporate debt has swelled.

The investment grade portion of the bond market stood at $ 3.8 trillion at the end of October, an increase of 6% from the same period a year ago, according to Fitch Ratings. BBB-rated bonds accounted for 58% of this total, up from 55% in 2017.

At the same time, however, debt defaults are actually expected to decrease.

Moody’s Investors Service predicts that corporate debt default levels will decline in 2019 to 2.3% from 3.2% this year.

“Our positive outlook for North American non-financial corporations reflects significant, albeit decelerating, GDP growth in the United States and the G-20 countries in 2019, and robust growth in emerging markets,” said Bill Wolfe, Senior Vice President of Moody’s. “Good liquidity and low refinancing risk favor a fall in the default rate, and exposure to gradually rising interest rates will generally be manageable.”

In addition to Yellen’s warnings, the Fed officials also recently noted that leveraged loans, which are granted to companies already in debt, present a significant risk.

But this part of the market has performed very well this year.

The Markit iBoxx USD Leveraged Loans Index has returned 1.98% year-to-date, while the Liquid Leveraged Loan Index is up 1.2%.

The average prices of offers from banks issuing the loans also increased, up 3.37% in the United States and 15.4% in Asia.

By comparison, the S&P 500 is down more than 1% and the Bloomberg Barclays US Aggregate Bond Index posted a total return loss of 1.8%.

Exits increase

None of this suggests that investors should be overly bullish on bonds, and recent behavior shows that money has left space.

Investment grade bond funds have seen cash outflows in 11 of the past 12 weeks, according to BofAML, to the tune of $ 3.8 billion in cash for investors, a total that represents just 0.1% of the total. total market. High yield funds have seen cash outflows for eight of the past nine weeks, amounting to $ 1.9 billion or 0.15% of total assets.

Despite its reduced default outlook, Moody’s warned that “highly leveraged issuers” are “potentially vulnerable as monetary tightening unfolds.” The rating agency also said that “the risk of downgrading or default is highest for low-rated companies that depend on third-party funding and need immediate market access.”

However, Moody’s also pointed out that only around 5% of companies considered to be speculative grade are considered to have low liquidity and are therefore in great danger.



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