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Big investors are cutting back their exposure to riskier corporate debt, in a bet that a huge rally in recent years has left the market vulnerable to a sell-off if the global economy falters.
Asset managers including BlackRock, M&G and Fidelity International have shifted towards safer corporate or government bonds, in response to a big decline in US credit spreads that means investors get little reward for taking extra risks.
Some investors fret that the rally, driven by the easing of fears over a global trade war and expectations of deeper interest rate cuts by the US Federal Reserve, has left the credit market pricing in an overly optimistic scenario for global economic growth.
“Credit spreads are so tight that there’s almost no ability for them to tighten further,” said Fidelity International fund manager Mike Riddell, referring to the extra yield offered by corporate bonds relative to ultra-safe government debt.
He cautioned: “If anything goes wrong in the world, then spreads can widen substantially.” Fidelity International has a short position against developed market credit in its global flexible bond funds, meaning it will benefit if spreads widen.
Investment grade bonds in the US and Europe now offer about 0.8 percentage points of additional yield over government debt, down from more than 1.5 percentage points in 2022 and close to their lowest since the global financial crisis.
Simon Blundell, co-head of European active fixed income at BlackRock, said this “relentless tightening” had prompted the world’s biggest asset manager to shift towards higher-rated and shorter-dated debt.
The market was “now priced for a Goldilocks scenario” of interest rate cuts and stable US growth, Blundell added, which was a “risk/reward [that] certainly lends itself to a defensive position in credit markets”.
In some cases credit spreads — a proxy for investors’ assessment of a borrower’s riskiness — have turned negative.
Bulls argue that ultra-tight spreads are justified by company balance sheets that have been strengthened in recent years and a US economy underpinned by expectations of at least four further quarter-point interest rate cuts from the Fed by the end of next year.
However, spreads have widened slightly in recent days as renewed trade tensions between the US and China — and nerves over the collapse of automotive parts supplier First Brands Group — puncture investors’ bullishness.
Paul Niven, head of multi-asset solutions at Columbia Threadneedle, said he had cut back his position in credit to “neutral” in recent weeks, selling high-yield bonds because the “asymmetry in terms of cost compared to government bonds is getting expensive”.
There have been signs of investor pushback in some riskier areas of the wider corporate debt market. A number of leveraged loans, including a $5.8bn issuance from speciality chemicals producer Nouryon and another deal worth more than $1bn from drugmaker Mallinckrodt have been shelved in recent weeks. Meanwhile, some outstanding loans have fallen in price as investors have instead opted for safer debt.
There have “been quite a few blow-ups in the last week or two and it’s shaking confidence”, said one trader of high-yield debt.
Some hedge funds are avoiding the debt of weaker companies, responding to what they see as indiscriminate tightening of spreads this year.
“Not only is the corporate credit market way too tight, it’s also equivalently tight between companies,” said Andrea Seminara, founder and chief investment officer of London-based credit hedge fund Redhedge. “There is lots of idiosyncratic risk which is completely unpriced [by the market].”
The overall yield on corporate bonds received by investors, known as the “all-in yield”, is still seen as attractive by many, due to rises in government bond yields in recent years. The yield to maturity on US investment grade bonds is about 4.8 per cent, according to an Ice index.
“Corporate bond yields are attractive and deserve to be owned now,” said Ben Lord, a fund manager at M&G Investments. But he added the firm was moving into higher-rated corporate credit and areas such as covered bonds issued by life insurers.
“The cost of switching out of BBB-rated unsecured bonds and buying these is as low as it’s ever been,” he said.
This article has been amended to clarify the investment portfolio referred to by Paul Niven