WHAT ECONOMIC DANGERS IS THE BOND MARKET PRICING IN? / THE WALL STREET JOURNAL

What Economic Dangers Is the Bond Market Pricing In?

Corporate debt was hit by the recent panic, but true concerns are mostly limited to a few corners of the market

By Jon Sindreu

Trading has normalized since earlier in the week. Photo: Vanessa Carvalho/Zuma Press

Even more so than stocks, bonds are often seen as an economic bellwether. 

If so, they are heading in a pretty positive direction.

The difference, or spread, between Treasury yields and the rate at which companies borrow has widened. 

Option-adjusted spreads on the investment-grade paper issued by blue-chip corporations closed at 1.11 percentage points Tuesday—an aftershock of the big stock-market selloff the day before. 

Spreads on debt issued by risky “high yield” issuers hit 3.81 percentage points. 

Both were the highest since last November. 

U.S. municipal bonds have been impacted as well.

However, trading has normalized since. 

The spread on high-yield bonds closed at 3.4 percentage points Thursday. 

This still implies a rise in the default probability to 5.7% from 5.1% at the end of May, despite the fact that, as of the latest June data published last week by Fitch, actual U.S. leveraged-loan and junk-bond default rates had inched down to 4.06%. 

But it is a small increase, and it may soon fully come back down.

Likewise, inflation expectations and yields on inflation-linked Treasurys—often seen as a gauge of long-term economic growth prospects—slumped during the market rout, but have now almost fully recovered. 

On Thursday, the S&P 500 ended up having its best day in nearly two years.

A key lingering concern for Wall Street is that the Federal Reserve may have left interest rates at prohibitive levels for too long. 

Recent lackluster economic data, as well as the equity rout that started last week, have led many investors to believe that the central bank is behind the curve. 

Markets are now pricing in that the Fed will need to start loosening policy aggressively starting in September. 

It is hard for investors to know just how much to worry. 

For one, the stock-market panic wasn’t really triggered by deep economic concerns, but rather a series of leveraged trades that went awry after the Bank of Japan decided to raise rates last week. 

And a lot of strong U.S. economic data—including the July survey of purchasing managers in the services sector, published Tuesday, and a better-than-expected jobless claims report released Thursday—is hard to square with a coming recession. 

Still, it is undeniable that U.S. job growth is weakening, global manufacturing is struggling to lift off and corporate earnings growth is mostly being driven by spending on artificial intelligence, which could well fail to deliver on its promise. 

The debt market is often thought of as providing a more grounded view of economic prospects. 

Volatility has forced some issuers to hit the brakes. 

The city of Chicago, financial-services firm ION Analytics and the telecom-focused real estate trust SBA Communications, for example, have delayed plans to tap debt markets.

Perhaps more concerning is that spreads on bonds rated triple-C or worse—the bottom of the barrel—had already been consistently widening before the latest rout. 

This suggests that higher-for-longer borrowing costs are slowly but steadily eating away at highly leveraged firms. 

That would be consistent with trends observed among cash-strapped small-capitalization stocks, and does suggest that central banks may need to end up lowering rates at a faster pace than they seem eager to at the moment.

Nevertheless, the recent whiplash hasn’t hit fixed income as directly as it did equities, a comparison of volatility-based indexes shows. 

And high-quality companies are already wading back into the debt market, including Japanese carmaker Toyota and A-rated utility Connecticut Light and Power. 

This makes sense: Even if spreads have widened, they are still low by historical standards, and the fall in Treasury yields caused by the market panic has more than offset the increase in borrowing costs caused by higher default probabilities.

Yes, balance sheets are getting stretched in some corners of the market, and episodes of volatility can do damage there. 

But the main victims appear to be those few that were already trading at distressed levels.

Most of the bond market has remained surprisingly robust. 

Investment-grade issuance in the first half of the year reached its second-largest volume in the past decade. 

For most companies, ample cash buffers and strong investor appetite to get a pickup over Treasury yields still seems to ward off dangers.

If bond traders aren’t panicking despite their penchant for pessimism, there is hope for everyone else.