Investors Are Left With Razor Thin Safety Nets Following Bond Market Boom

Bond buyers are settling for the smallest extra yield in years to take on default risk, as a potent mix of economic optimism and an abundance of cash chasing limited securities drives valuations higher.

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Credit spreads the premium investors earn on riskier assets compared with safe-haven Treasuries continue to tighten globally. With market volatility subdued, investors are piling into assets that promise better carry, from corporate bonds to emerging-market currencies.

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Investment-grade U.S. corporate bonds now offer some of the narrowest spreads since before the dot-com bubble burst. Meanwhile, the costliest category of bank bonds is flirting with record valuations. In an unusual twist, a few issuers are even trading below Treasury yields, turning their spreads negative for the first time.

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While there is some improvement in corporate fundamentals, bankers and fund managers largely attribute the rally to an influx of capital hunting for fixed-income opportunities. Yields remain attractive relative to the past decade, luring pension funds and insurers eager to lock in higher rates.

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“There’s just so much cash chasing financial assets,” said Robert Cohen, head of global developed credit at DoubleLine Capital. “Everyone wants a bargain and when they appear, they disappear fast.”

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Global investment-grade spreads averaged 81 basis points on Wednesday, near their tightest since 2007 and well below the five-year average of 116 basis points. Some of this compression reflects stronger balance sheets, with metrics suggesting companies can easily service debt. At the same time, major central banks are easing monetary policy, lowering borrowers’ costs.

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Technical factors are also in play. The rise in absolute yields over recent years has spurred a wave of strategies designed to capture higher rates, shifting the demand-supply balance. Passive credit index managers and fixed-maturity funds have helped flatten yield differences among bonds, while insurers continue to wrap corporate debt into annuities for retirees further fueling demand.

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For cautious investors, today’s valuations present a dilemma. They can stay on the sidelines and risk missing out on a rally driven by excess liquidity, or settle for lower returns from safer assets as volatility remains muted.‍

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FOMO Takes the Lead

For now, fear of missing out is winning. That same sentiment is pushing global equities, gold, and even Bitcoin to record levels.

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“Much of the credit market looks expensive to us, yet plenty of buyers are still searching for yield wherever they can find it,” said Alexandra Ralph, senior fund manager at Nedgroup Investments in London. “Frankly, there are worse places to look than liquid, public credit markets.”

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When equities soar and yields climb, retirement funds with fixed credit allocations typically rebalance by selling stocks and adding bonds, notes Citigroup strategist Daniel Sorid.
“The combination of strong equity markets and rising yields has triggered significant systematic flows into fixed income from U.S. target-date strategies,” Sorid said.

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One striking example of yield-chasing came when Allianz SE sold $1.25 billion in perpetual notes this month setting a new low for spreads among financial firms this year and still drew an eye-popping $12.5 billion in orders.

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Boom or Bubble?

Emerging-market borrowers are also enjoying record-low risk premiums. According to JPMorgan Chase, spreads on their dollar-denominated bonds dipped below 260 basis points earlier this month a level not seen since 2013. In Asia, investment-grade spreads tightened to a record low of 60 basis points this week, less than half their 10-year average. Junk bonds are similarly compressed, with risk premiums near post-crisis lows, indexes show.

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Such indiscriminate buying alarms some seasoned investors.
“When markets stop differentiating between strong credits and shaky ones, it usually means liquidity not fundamentals is setting prices,” warned Guillermo Osses, head of discretionary EM debt strategies at Man Group, the world’s largest publicly listed hedge fund.

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That leaves little margin for error if the economy slows. Recent U.S. jobs data and weakening services activity hint at potential cracks.

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“The U.S. economy could start cracking next year,” predicted Luke Hickmore, investment director at Aberdeen Investments. He expects investment-grade spreads to widen back to 130-140 basis points over the next 12 months, up from 76 basis points on Tuesday. “This feels great right now, and maybe it gets even tighter but it’s a fragile setup,” Hickmore added.

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