July 10, 2023Scroll down
No reversal yet from last year’s bond market rout
After a brutal 2022, some investors hoped for a bond market comeback this year. Those expectations have been shattered in 2023 as Fed rate cuts anticipated by some—not by us!—failed to materialize due to a robust job market and inflation that turned out to be as sticky as we imagined. Consequently, bondholders are effectively flat in 2023, buoyed mostly by coupon income from relatively high yields (see below). So far this year, the 10-year Treasury yield has remained in a narrow range near its current level of 3.75%, as US economic strength, a tight labor market, and high inflation have conspired to keep the Fed on a hawkish footing for the foreseeable future.
Higher neutral rate could dampen rebound
There has also been talk of a potential upward adjustment by the US central bank to its estimate of the so-called ‘neutral rate’: the rate of interest that is considered neither accommodative nor restrictive, but rather ‘just right’ in equilibrium to avoid inflation and keep employment and the economy humming along. Of course, a higher terminal rate means less easing when the time comes and a smaller bounce in bond returns. Supply and demand in the Treasury market also have an impact. Given the US government continues running unsustainable budget deficits—with pandemic-era spending and new investments in supply chain shifts and green energy reform further swelling the budget—that inevitably requires higher longer-dated rates to balance borrowing demand with a shrinking savings supply and less interest in US bonds from Russia and China due to sanctions. Moreover, with increased uncertainty around future inflation, investors will seek higher premiums to compensate for the risk of holding longer-term bonds. All in all, we see Treasury yields staying high for some time, punctuated by flight-to-safety rallies during times of stress.
What do higher rates mean for corporate borrowers?
One revelation in the most recent FOMC meeting minutes was that most Fed officials anticipate at least one more 25bps rate increase this year, with the aim of keeping the Fed Funds rate above 4% through the end of 2024. Combined with an already recessionary outlook for the US economy, such an elevated rate will be disappointing to CFOs looking to raise new capital or refinance their existing debt. The latter challenge has been referred to as the ‘refinancing wall’: approximately $2.6 trillion in corporate debt set to mature by the end of 2025, much of which will need to be rolled into new bonds. From mid-2020 to early 2022 low rates amidst pandemic stimulus gave companies an opportunity to raise a huge amount of capital. As a result, despite aggressive rate hikes over the last 15 months, many companies avoided credit-related strain because they had no need to tap the debt market. This tendency of borrowers to let the clock tick down on refinancing has had the effect of driving the average maturity of junk bonds to just over five years—the lowest level on record (see below).
Quantifying the surge in borrowing costs
With the need for refinancing becoming more pressing, the shield from rate hikes provided by pandemic issuance will not endure unless there is a significant improvement in corporate profitability to offset this drag. Short of that, as firms commence refinancing their debt at higher interest rates, borrowing costs will swell and companies’ credit fundamentals will take a hit. The cost of servicing debt was already rising faster than EBITDA for the median borrower as of Q4 2022, and the rate of deterioration has only accelerated since. That has resulted in a big hit to many firms’ interest coverage ratio, a standard measure of solvency calculated as EBIT divided by interest expense. In a recent note, S&P Global Ratings reported a decline in the median borrower’s interest coverage ratio from 7.1 at the end of last year to 6.4 for the first quarter of 2023. That’s quite a comedown from the peak of 9.0 reached in 2022.
Firms differ in their ability to absorb the hit
Naturally, a company’s tolerance for higher debt costs and the refinancing hurdle described above will depend on many of its own characteristics, including its credit quality. In light of that, we expect to see a growing divergence in the credit market, with spreads widening disproportionately for lower-quality borrowers, especially as macro conditions worsen. That view is borne out in S&P Global Ratings data, showing that for high-yield ‘junk’ borrowers with credit ratings of BBB- or worse, the decline in interest coverage was sharper, falling from 3.3 at the end of 2022 to 2.9 in Q1. This downward trend impacted nine of ten sectors, only sparing materials firms. Larger and higher-quality borrowers should fare better, in part because they’re better able to manage balance sheets by deleveraging.
We see plenty of risk, little reward in high yield
How could things play out, going forward, and what does this mean for high yield bonds? We’ve often talked about recession, and the Fed’s own model currently predicts a downturn by June 2024 with 67% probability. Along those lines, we note that the US Treasury yield curve is as inverted as it’s been in over four decades. If earnings growth declines further by the end of 2023, interest coverage ratios could indeed approach recessionary lows, leading to a substantial increase in the number of companies under such stress. Moreover, these calculations only consider existing debt, such that upcoming issues will place additional pressure on non-investment-grade firms’ creditworthiness. None of this precariousness would be obvious from a look at credit spreads, with the ICE BofA US High Yield Index Option-Adjusted spread sitting at just 4.1% as of July 6th—well below its long-term average of 5.4%, and not enough of compensation for risk, in our view, for high yield maturing beyond 2023.
Finally, a downside surprise in new jobs for June
Last Friday’s Bureau of Labor Statistics (BLS) report saw US employers adding 209,000 jobs in June, falling short of a consensus forecast of 230,000 new hires, and way down from the final tally of 306,000 jobs added in the prior month, with both May and April figures revised downward (see below).
These softer-than-expected numbers represented the first miss versus expectations on a monthly BLS report in 15 months—just possibly a bit of early evidence Fed tightening is finally hitting what has been an ultra-hot labor market. For the first six months of this year, average monthly payroll growth was 278,000, down from nearly 400,000 in 2022. And yet, despite the slowdown in job growth, unemployment actually dipped to 3.6% in June, down from 3.7% in May. On top of that, data on wages showed that employers continued boosting pay as they vied for a limited pool of workers, resulting in a 4.4% year-over-year increase in average hourly earnings in June, matching the gains seen in the previous two months and remaining significantly higher than the pace before the pandemic.
Is this good news or bad news?
Overall, the numbers hint to us the possibility that Fed policy is beginning to take a toll in the labor market, but this is far from a decisive change. Bulls will interpret the modest dip in nonfarm payroll growth as a sign that Fed policy is moderating unsustainable labor market strength, but not crashing the economy in the process, favorably adjusting the odds of a quick end to Fed tightening and even the likelihood of a soft landing scenario on the heels of Friday’s report. Sentiment was much gloomier a day earlier, when a scorching 497,000 jobs added in the ADP private payroll report spooked markets ahead of the BLS release. At the margin, we’re also encouraged by Friday’s numbers, but see this as too-modest progress in slowing job growth: highly unlikely to sway the FOMC this month from what we believe will be a resumption of 25 bps hikes at its July meeting, and ultimately not nearly enough to bring down core inflation at a rate that would permit the Fed to pivot. We also note that a cooling of the job market typically trails a slowdown in the broader economy, so if we are headed into a Fed-induced recession, investors probably need to prepare themselves for fewer such ‘Goldilocks’ reports in the year ahead.