Fed's Big Cut is Fueling Valuation Anxiety

Investors have been increasingly pouring money into corporate bonds, which has caused risk premiums to tighten. Additionally, the Federal Reserve's recent interest rate cuts are fueling optimism that the U.S. may avoid a recession. However, some money managers believe the market is becoming too complacent and may be overlooking potential red flags.

‍

Simon Matthews, a senior portfolio manager at Neuberger Berman, notes that several factors suggest that the market may not be as stable as it appears. He highlights concerns around the upcoming U.S. election and weak economic growth in Germany, which he says is at its lowest since before the pandemic. Consumers are also facing financial strain, while China's economic growth continues to slow. When these issues are considered together, Matthews believes it's concerning that credit spreads are tightening as much as they are. He does acknowledge that lower borrowing costs could ease some of the economic headwinds, but he remains cautious.

‍

Despite these concerns, investors have largely ignored these potential risks, diving into riskier segments of the credit market in search of higher yields. In particular, the lowest-rated bonds have been outperforming the broader junk bond market. There is also growing demand for Additional Tier 1 (AT1) bonds, which are high-risk instruments that can require investors to take losses if a bank experiences financial trouble.

‍

The expectation among buyers is that lower borrowing costs will help highly indebted companies refinance their debt and extend the maturities on their obligations. This would limit the number of defaults and help maintain valuations. With short-term interest rates dropping, many investors are expected to shift their focus from money market funds to medium- and long-term corporate bonds, which could lead to further tightening of credit spreads.

‍

However, there are still risks to this optimistic outlook. Inflation could rise again if consumers start spending more due to the lower interest rates, according to Hunter Hayes, the chief investment officer at Intrepid Capital Management Inc. He warns that the Federal Reserve may need to raise rates again, as it has done in previous inflationary cycles. If that happens, the appeal of high-yield bonds could diminish quickly.

‍

With U.S. monetary policy likely to remain relatively restrictive, some market participants are keeping a close eye on the financial health of companies that rely heavily on floating-rate debt. According to a note from BlackRock researchers Amanda Lynam and Dominique Bly, any deterioration in fundamentals could have significant repercussions for these borrowers, particularly those with lower credit ratings.

‍

Companies rated CCC, for example, remain under pressure despite their debt performing well in recent months. Lynam and Bly point out that these firms tend to have low earnings relative to their interest expenses, and borrowing costs for CCC-rated companies are still hovering around 10%. This is a significant burden for smaller companies, especially those that need to refinance in the wake of the "easy money" era, making them vulnerable to default even if interest rates continue to fall.

‍

Any sign of weakness in the labor market could also have a negative impact on credit spreads. JPMorgan Chase & Co. analysts, including Eric Beinstein and Nathaniel Rosenbaum, argue that a softer job market would heighten fears of a recession and put downward pressure on yields, creating a challenging environment for corporate bonds.

‍

Nevertheless, concerns over valuations remain relatively modest, and most investors continue to hold overweight positions in corporate debt. According to analysts at BNP Paribas, the start of a rate-cutting cycle should support demand for non-cyclical sectors over cyclical ones in the investment-grade market. They note that industries such as health care and utilities, which have seen limited bond issuance, have more room for spread compression, making them attractive to investors.

‍

Meghan Robson, head of U.S. credit strategy at BNP Paribas, agrees, stating that this is a prime opportunity for non-cyclicals to outperform their cyclical counterparts. In her view, cyclicals are currently overvalued, and the market should begin to favor sectors that are less sensitive to economic cycles, such as health care and utilities.

‍

While the market is currently leaning toward optimism, several underlying risks suggest that the path forward may not be as smooth as some investors hope. With factors such as inflation, weak global growth, and potential labor market troubles on the horizon, caution may be warranted as the credit market continues to evolve.

‍