Inflation Poses High Risk for Investment-Grade Bonds

With inflation fears rising and interest rates looking increasingly likely to be hiked soon, investment-grade corporate bonds are at high risk of getting hit in the coming months, according to Morgan Stanley.

The Federal Reserve is more likely to hike rates sooner after last week’s U.S. inflation report, and an index of expectations for future bond yield swings has reached its highest level since April 2020. With current high valuations, there’s little room for error, and even slight stresses can weigh on returns, Morgan Stanley strategists including Srikanth Sankaran wrote. On top of that, corporate earnings are increasingly at risk from supply-chain problems and wage pressure, the strategists wrote.

Add it all up, and the “likelihood of a mid-cycle correction is high,” particularly in the early part of next year, the strategists wrote in a note dated November 14.

Concerns about inflation are at their highest level since 2012 by at least one measure: A November survey of credit investors by Bank of America Corp. showed that 73 percent are worried about rising price levels, the highest percentage in almost a decade, strategists led by Yuri Seliger and Oleg Melentyev wrote in a note on Friday. It remains the top risk that investors cite. In government-debt markets, expectations for the pace of inflation over the coming decade climbed on Friday to a level unseen since 2006.

Some corporate bond investors are responding by buying shorter-term securities, whose price is less hurt by rising yields. Risk premiums in corporate bonds broadly edged higher last week, but longer-dated securities were hit harder. Those maturing in more than 10 years widened by about 2.4 basis points (bps), while those maturing in less than a decade expanded by less than 1 bps.

“We’ve been running short duration in our portfolios,” said Gregory Staples, head of fixed income at DWS North America.

With rising inflation and rate hike fears, an exchange-traded fund (ETF) that tracks investment-grade corporate bonds on Friday suffered its second-largest day of outflows ever, of around $1.5 billion. The IShares iBoxx $ Investment Grade Corporate Bond ETF (ticker LQD) has seen $16 billion of outflows so far this year—the most of any U.S. ETF.

Amid what may be higher demand for shorter- and intermediate-term securities, some companies are selling bonds that focus on those maturities. HSBC Holdings Plc sold $6 billion of bonds, $4.25 billion of which mature in six years or less, and the longest part of which is due in 11 years. Ameren Corp., a utility holding company, sold a $500 million deal maturing in five years.

High-yield bond investors are also spooked. U.S. junk-bond yields are under pressure from renewed inflation concerns, and had their biggest weekly jump in six months to close at 4.23 percent on Friday. Yields have risen for all junk-bond rated debt, with BB yields up the most in six months, to close at 3.17 percent, while single B yields rose the most in eight months, to 4.66 percent. The asset class last month posted its first back-to-back decline on a total return basis since the pandemic shuttered the U.S. economy in 2020, data compiled by Bloomberg show.

Allspring Global Investments, formerly Wells Fargo Asset Management, has been “really concerned” about inflation since the start of 2021 and has been cutting duration to express that view, according to Janet Rilling, head of multisector fixed income plus at the firm.

While many companies have been able to offset higher cost of goods and operating expenses by raising prices, given the strong demand for their products, PGIM Fixed Income is watching out for margin compression in fourth-quarter numbers as well as the 2022 outlooks, according to Terence Wheat, co-head of U.S. investment grade corporate bond team at the firm. PGIM Fixed Income oversees $964 billion.

“Amazon was a noteworthy name in the third quarter, as their margins were compressed, albeit at solid levels,” said Wheat in an emailed response to questions.

Current high-grade corporate spreads averaged around 0.88 percentage point as of Friday’s close, according to Bloomberg index data. Morgan Stanley sees investment-grade spreads potentially widening out above 1.1 percentage point in the first half of next year, before settling back to end the year around 1 percentage point.

Elsewhere in credit Markets:

Americas

High-grade borrowers announced at least 14 new bond offerings Monday as companies rush to capitalize on favorable issuance conditions ahead of next week’s U.S. Thanksgiving holiday. The day’s calendar represents the busiest since September 8, according to data compiled by Bloomberg.

• U.S. investment-grade bond sales may be in store for the second-most active year on record in 2022, with potential volume of $1.35 trillion, JPMorgan Chase & Co. analysts wrote in a note Monday.
• In high-yield issuance, four companies are in the market with new deals, including a $650 million transaction from Travel + Leisure Co. and a $350 million offering from Dana Inc.
• Bonds issued by Sinclair Broadcast Group’s sports networks were the biggest high-yield decliners on Monday after the unit was left out of a key deal struck between Sinclair and Dish Network Corp.
• Some Casper Sleep Inc. investors found their nightmare was finally over when the company on Monday agreed to be acquired by Durational Capital Management for $6.90 per share, sending the stock surging.
• A key Citigroup Inc. rainmaker in Texas is faced with reviving the bank’s public-finance business there after GOP officials sought to punish the firm for its gun policies, triggering an unprecedented pullback from underwriting in a fast-growing state.

EMEA

This week could be the last proper full week of issuance for the year, as next week’s U.S. Thanksgiving holiday normally marks the start of a seasonal slowdown in activity until the new year. On Monday, nine issuers priced a combined 6.1 billion euros (US$6.96 billion) equivalent of debt.

• Deutsche Bank AG is planning to issue a junior bond that will test the depth of investor appetite just as Germany’s biggest lender embarks on the final year of a broad restructuring plan.
• BT Group Plc moved to shield bondholders from potential losses amid reports that Altice founder Patrick Drahi plans to increase his stake in the U.K. telecommunications company.

Asia

Chinese junk dollar bonds are rebounding further after their biggest gain in 20 months last week following signals that measures to ease property-sector distress are on the way.

• Two UBS Group AG portfolio managers are leaving after a $3 billion fund got caught up in China’s high-yield bond meltdown.
• Citic Securities Co. is seeking to hire some 30 people for its fixed-income business overseas to tap what it sees as growing long-term demand for Chinese debt as the nation opens its capital markets.
• Hong Kong is considering an offering of green bonds denominated in euros and dollars, a person familiar with the matter said.

—With assistance from James Crombie, Emily Graffeo and Katie Greifeld.

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