Rating anxiety is fueled by the Fed’s Big Cut: Credit Weekly

(Bloomberg) — Investors are pouring money into corporate bonds, risk premiums are tightening and the Federal Reserve’s interest rate cut is rekindling hopes that the U.S. will avoid a recession.

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Some money managers say the market is too complacent now to worry.

“The US election is coming up and expectations for economic growth in Germany are some of the weakest since pre-Covid,” said Simon Matthews, senior portfolio manager at Neuberger Berman. “Consumers are feeling the pinch and China’s growth is slowing. When you put all that together, it doesn’t tell you that credit spreads should be close to tight,” he added, noting that falling borrowing costs will help reduce some of the headwinds.

Investors brushed aside potential downsides and dived deeper into the riskiest corners of credit in search of higher yields. The lowest-rated bonds are now outperforming the broader junk bond market, while demand for additional Tier 1 bonds, which can force losses on investors to help a bank survive turmoil, is expected to increase.

Buyers are betting that lower borrowing costs will allow debt-laden companies to refinance and extend maturities, limiting defaults and supporting valuations. And as short-term rates fall, investors are expected to shift their allocations to medium- and long-term corporate debt from money markets, which could cause spreads to tighten further.

Still, inflation could start rising again if consumers start spending more as interest rates are cut, according to Hunter Hayes, chief investment officer at Intrepid Capital Management Inc.

“Who knows, maybe the Fed funds rate has to come right back up like it did in previous inflationary cycles and then all of a sudden high-yield bonds are a lot less attractive again,” he said.

With U.S. monetary policy likely to remain tight, market participants are also watching for signs of deteriorating fundamentals, particularly among borrowers exposed to floating-rate debt, wrote BlackRock Inc. researchers Amanda Lynam and Dominique Bly, in a note. In addition, CCC-rated issuers generally remain under pressure despite their recent debt performance, they wrote.

The story continues

They cited low levels of earnings that companies have overall compared to interest expenses. Borrowing costs for CCC-rated firms are still around 10 percent — crippling for some small companies when they need to refinance after the end of the easy money era — and leave them at risk of default even as rates fall.

Any weakness in the labor market would also be “a headwind for spreads as it will increase recession fears and lower yields,” JPMorgan Chase & Co. analysts, including Eric Beinstein and Nathaniel Rosenbaum, wrote in -a research note last week.

Of course, valuation concerns remain modest and investors are largely overweight corporate debt. The start of the rate-cutting cycle should also support demand for non-cyclicals versus cyclicals in the investment-grade market, analysts at BNP Paribas SA wrote in a note.

In particular, limited issuance by health care firms and utilities provides room for spread compression, they added.

“It’s a great opportunity for non-cyclicals to outperform,” Meghan Robson, head of U.S. credit strategy, said in an interview. “We think cyclicals are overrated.”

The week in review

• Traders are betting on continued easing by the US central bank after it cut interest rates by half a percentage point on Wednesday – its first cut in four years. The historic move ended weeks of speculation about whether the Federal Reserve would begin its easing cycle with a quarter or half point cut.

  • The reduction is supportive of credit spreads in general, but will encourage corporate bond issuance – particularly from high-yield issuers. The cut is likely to favor borrowers at the beginning of the yield curve, rather than the tail end, according to market participants polled by Bloomberg.

  • Spreads on credit derivatives fell on Wednesday after the move, to their lowest level since the pandemic

  • However, Fed Governor Michelle Bowman warns that the 50 basis point cut “could be interpreted as a premature declaration of victory” over inflation.

  • In other central bank news, the Bank of England kept rates unchanged and warned investors that it would be in no rush to ease monetary policy

• Wall Street banks burned two years ago after backing big corporate buyouts and ending up with tens of billions of dollars of “suspended debt” are now back for more, preparing to underwrite more LBOs European ones.

• Companies taking advantage of lower funding costs to win better terms on existing debt or eliminate maturities borrowed the most from the U.S. leveraged loan market in seven years.

• Liquidators of China Evergrande Group, the world’s most indebted builder, are returning to a Hong Kong court as they seek to liquidate a subsidiary with key assets.

• UBS Group AG is leading a $1.15 billion financing package to support Vista Equity Partners’ acquisition of software company Jaggaer, beating out direct lenders that were also competing for the deal.

• Apollo Global Management Inc. has secured $5 billion in fresh firepower from BNP Paribas SA as it looks to grow a key lending business, digging deeper into terrain once dominated by banks.

• A much larger share of managers in the $1 trillion U.S. collateralized loan market are able to buy and sell loans more freely than once feared after a wave of refinancing and resets pushed back the clock on reinvestment limits.

• In the world of private credit, the capital markets arm of KKR & Co. led a financing for USIC Holdings to help repay generally syndicated debt, while Oak Hill Advisors provided $775 million to support Carlyle Group Inc.’s acquisition of Worldpac and Alegeus. Technologies aims to get about $75 million in interest savings by refinancing the private loan that Vista Equity Partners used to take the company private in 2018.

• Tupperware filed for bankruptcy after years of struggling with declining sales and increasing competition.

• Bankrupt trucker Yellow Corp. and its hedge fund owners lost a key court ruling on more than $6.5 billion in debt the pension funds say the defunct company owes them, likely wiping out most of the shareholder recovery.

• Bausch Health Cos. is working with Jefferies Financial Group to explore refinancing some of its debt to support a long-planned spin-off of its stake in eye care company Bausch + Lomb.

In motion

• BlackRock Inc. is reviewing its private credit business. The firm is establishing a new division, Global Direct Lending, appointing Stephan Caron, head of the European middle market private debt business, to lead it. Jim Keenan, global head of BlackRock’s private debt business, will leave the firm next year, as will Raj Vig, co-head of US private equity.

• Silver Point Capital has hired Joseph McElwee from Investcorp as head of capital markets secured loan obligations and structuring.

• Jefferies Financial Group Inc. hired former Citigroup Inc. banker Simon Francis in a newly created role leading its debt financing business in Europe, the Middle East and Africa.

• Fidelity Investments has recruited former Vista Credit Partners executive Lendell Thompson as it continues to expand into the private credit market. He will be managing director in the firm’s direct lending team.

–With assistance from Dan Wilchins and James Crombie.

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