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Junk bond traders should check with economists

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U.S. junk bonds pay investors a paltry premium for the risk of keeping them in an impending recession. Either spreads have to widen or the clouds of recession have to clear, but something has to give.

Consider the first possibility, the base case. Junk spreads generally follow recession risk closely, and economic gloom has steadily mounted over the past nine months. In particular, the median economist in Bloomberg survey data predicts a 50% chance of a recession next year, and yield curve-based indicators also warn of a slowdown. Yet high-yield spreads still sit 4.52 percentage points above the Treasury curve on an options-adjusted basis, in line with their average over the past decade, according to the Bloomberg US Corporate Index. High Yield.

If you think the economists are right, then this gap is bound to widen. Economists may have a poor track record for calling recessions, but that’s usually because they’re too conservative. They fail to predict recessions or come too late, but almost never predict ones that won’t happen, as an IMF working paper found. In that sense, economists are the opposite of the specter of stock market hysteria, which gets riled up about false signals all the time.

Of course, economists have good reason to worry. The Federal Reserve is raising interest rates at breakneck speed to fight the worst inflation in 40 years, and that process will lead to economic hardship, a fact Fed Chairman Jerome Powell emphasized in his annual address on Friday. in Jackson Hole, Wyoming. Resilient consumer spending and a strong labor market may mean that corporate and household debt ratios remain healthy for a few quarters, but interest rate hikes take 18-24 months to reach their full effect, and the central bank has clearly not finished increasing yet. Meanwhile, China’s economy is slowing and Europe faces even greater recession probabilities than the United States, creating headwinds from key trading partners.

But what if it really is much ado about nothing and the proverbial “soft landing” occurs? Obviously, the market must assign some probability to this outcome. So let’s take the economists’ 50% recession probabilities and assume there are equal chances of a non-recessionary bullish case that brings spreads down to around 325 basis points. On the other hand, let’s assume (optimistically) that the potential recession that everyone is so worried about would not be particularly deep and would send spreads to around 800 basis points. Based on these assumptions, fair value is likely around 563 basis points, 1.11 percentage points above Friday’s close and close to the widest spreads of the year.

What can explain the disconnection? Part of this likely comes down to a version of the “there is no alternative” sentiment – ​​TINA, as it is called – that was pervading the stock markets. Downside risks are plentiful for the stock market, and commodity markets may have peaked after the early 2022 rally, so perhaps corporate bond risk doesn’t look so bad in comparison. As my colleague at Bloomberg Intelligence, Noel Hebert, often reminds me, it would be unusual to lose money buying and holding the high yield index with yields around 8%, provided you have some years to remain patient. On the other hand, spreads may be just one last vestige of a tasteless summer risk surge that is slowly unraveling across all asset classes.

Either way, new investors are unlikely to line up to fund high-yielding companies if markets offer only 4.52 percentage points of spread for their troubles. Either way, the status quo is not sustainable. In the medium term, this could mean anything from a spike in yields and default rates to the rare and coveted “soft landing,” but the least bond traders can do is meet somewhere in the middle. . For now, they are still in the fantasy world.

More other writers at Bloomberg Opinion:

• What the Hawks didn’t get in Jackson Hole: Daniel Moss

• Powell must back his words with actions: Bill Dudley

• Jerome Powell fights inflation — and wins: Karl Smith

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.

More stories like this are available at bloomberg.com/opinion