High yield bonds not pricing in recession risks
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HIGH YIELD BONDS NOT PRICING IN RECESSION RISKS
High yield bonds have benefited from strong risk appetite this year, but investors should be wary as they are not pricing in the likelihood of an approaching recession, according to BCA Research.
“We have high conviction that the US economy will tip into recession in the next 6-to-12 months. Continued labor market deterioration will deprive consumption of its main driver at the same time that excess savings are drying up and banks are tightening lending standards to consumers,” BCA analysts said in a report.
But “spreads have so far ignored the deterioration in the labor market. Junk bond spreads are typically correlated with 12-month changes in the unemployment rate but these two series have diverged widely since the beginning of last year,” the research firm notes.
BCA has a “maximum underweight” ranking on high yield bonds. It adds that “investment grade and high-yield bonds currently offer the least attractive risk/reward profile among all US spread product sectors.”
Meanwhile, analysts at Morgan Stanley say that investors that want to protect against the risk of a “hard landing” should hedge their bond holdings, rather than broadly selling them. This can be done by selling high yield total return swaps or through put spreads on the high yield CDX index.
Bond holders could also de-risk in areas “where recession risks are most underpriced,” including single-B rated high yields bonds. Here, “valuations are rich... and positioning is extended,” Morgan Stanley said.
(Karen Brettell)
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