Via Financial Times

US junk bonds may fall “significantly” after a rally this year that has left the riskier end of the corporate bond market in a perilous state, Moody’s has warned.

The rating group’s capital research arm said late on Thursday that the strong gains in high-yield credit in 2019 have left borrowing costs out of line with the business climate.

“High-yield bonds have rallied mightily despite the lack of any observable broad-based acceleration of either business sales or corporate earnings,” Moody’s said in a report led by economist John Lonski.

“If the anticipated improvement in the fundamentals governing corporate credit quality do not materialise, a significant widening of high-yield bond spreads is likely.”

The spread or difference in yield between junk bonds and Treasuries — a measure of the premium investors demand to hold the bonds — has pulled back significantly this year as yields have declined. The fall in yield points to a rise in price.

On Thursday, the spread on US junk bonds was 354 bps (3.54 percentage points), down by 200 bps from a January peak, according to a closely watched Intercontinental Exchange index. The asset class has delivered returns, including coupon payments, of 12 per cent this year — the strongest performance since a rebound in 2016 that followed a wobble the previous year.

Line chart of Bps showing US junk bond spreads recede

Investors have had to hunt higher and higher on the risk spectrum in a global market that has been starved for yield, providing a boost to lowly-rated credits.

Moody’s cautioned, however, that high-yield bonds now appear to be expensive relative to the fundamentals implied by a variety of economic and market gauges even if spreads are not especially low by historic standards.

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The report notes that a model including elements like expected default rates, private-sector employment and a Federal Reserve national economic index suggests spreads should be in the 420 bps to 480 bps range.

At the same time, “the high-yield bond market has effectively ignored a comparatively elevated ratio of downgrades to upgrades for US high-yield credit rating changes,” Moody’s said. The ratio during the fourth quarter of 2019 is set to come in at around 1.86 downgrades for each upgrade, “well above” the 1.32-to-one median recorded during each quarter stretching back to 1986.

Wall Street analysts are optimistic for profits next year: earnings per share of groups listed on S&P’s composite 1,500 index are forecast to rise 10 per cent next year, after stalling in 2019, FactSet data show. Still, economic growth is expected to ease from and estimated 2.3 per cent in 2019 to 1.8 per cent in 2020.

Moody’s warning echoes that of other high-profile names in the fixed income market who have recently said high-yield bonds may be vulnerable.

Jeffrey Gundlach, chief executive of DoubleLine has said “losses will be huge when the economy turns down”. Pimco, the bond-focused manager that oversees almost $1.9tn in assets, has said it remains “cautious” even as “central banks are accommodative and near-term sources of uncertainty have been reduced.”

Column chart of Total return (%) showing 2019: A strong year for high-yield credit returns