Here's why corporate bond investors are selling

by Cecile Gutscher and Cormac Mullen

Corporate bond investors finally joined a selloff that has shaken stocks to Treasuries as investors spooked by U.S. interest-rate risk headed for the exits.

Investors pulled $14.1 billion from debt funds, the fifth-largest stretch of redemptions in the week through Feb. 14, according to a Bank of America Merrill Lynch report, citing EPFR data. High-yield bonds lost $10.9 billion alone, the second highest outflow on record. As benchmark Treasury yields traded at a four-year high, it shook the foundations of a key support for risk assets -- low rates.

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“Investors don’t sell their cash bonds in a big way until they are forced to, which happens when the outflows start picking up more sustainably,” Morgan Stanley strategists led by Adam Richmond wrote in a recent note to clients.

Creeping corporate leverage is setting the stage for a broader market meltdown while higher real rates drive down asset values, according to Morgan Stanley strategists, who project negative returns for corporate bonds in the U.S., Europe and Asia in 2018. They warned that companies would struggle to refinance rising debt loads, just as rates rise and a tide of ‘tourist’ investors who’d dabbled in riskier debt abandon ship.

“It’s a wake-up call that central banks are withdrawing liquidity, and that the process is not going to be smooth,” Morgan Stanley strategist wrote.

The iShares iBoxx $ Investment Grade Corporate Bond exchange-traded fund posted a record one-day outflow Wednesday, the most among U.S.-listed passive vehicles across asset classes.

These indicators may signal the tide is shifting. As recently as last week, corporate obligations outperformed -- anchored by long-term investors that stayed put while gauges of stock and rates volatility surged. Risk premiums on corporate bonds widened by a modest 10 basis points even as global stock indexes flashed bear-market signals.

Borrowers, for their part, have plowed on with new debt sales after a brief hiatus earlier this week. In Europe, a number of higher-risk issuers including German hire car firm Sixt SE returned to the primary market yesterday, while U.S. investment-grade activity carried on.

Axa IM, meanwhile, is sticking to its bullish call, arguing corporate bond markets will only feel a mild impact from higher real rates. Strategists at the firm forecast the impact of a 1 percentage point increase in U.S. Treasury real rates would cause a 15 basis point widening for investment-grade bond spreads and 18 basis points for lower-grade debt.

“We do not expect a protracted correction in credit risk premia,” according to Axa IM’s London-based senior credit strategist Greg Venizelos.

And beneath the surface, pain metrics have been building up of late.

Derivatives tied to corporate bonds moved more than the underlying cash debt last week -- another sign that investors sold more liquid holdings during the equity turmoil rather than offload harder-to-sell debt, according to JPMorgan Chase & Co.

Meanwhile, options on an index of derivatives tied to corporate credit -- typically used to hedge against a broad correction -- also saw a pick-up in volumes, according to market participants. Responses to JPMorgan’s monthly credit survey -- conducted in the midst of the market turmoil -- also took a decidedly pessimistic turn, with just 16 percent saying they were bullish compared to 30 percent the month before.

“As the days of low inflation, low rates and low volatility are coming to an end, investors are realizing that the Fed party is over,” said Federated Investors Inc. money manager Gene Neavin. “When spreads get tight that’s when interest rates play more of a factor.”


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