- Data from Morgan Stanley shows there’s been a sharp rise in the yields on riskier high-yield debt in US corporate bond markets.
- Morgan Stanley says the bear market in corporate credit is underway.
- Challenging credit conditions are likely to be exacerbated in 2019, as liquidity continues to tighten.
The steady withdrawal of liquidity by major central banks has been a central feature of global markets in 2018.
And if you’re wondering how that’s starting to effect corporate bond markets, this chart from Morgan Stanley is illuminating:
As the chart shows, different grades of corporate credit have been effected “one by one”.
Firstly, yields on European investment grade (IG) bonds and emerging market bonds began to rise. US IG bond yields have also edged higher.
But of particular note is the orange line, which shows the spread between riskier US high yield (HY) corporate bond yields, and benchmark US interest rates.
The spread largely trended lower until about a month ago. Since then, it’s risen by almost 100 basis points.
It means the total return on HY debt is now just “roughly flat” for the year,
That’s “despite very strong earnings growth, a solid US economy” and a 30% fall in HY bond issuance — all factors which reflect the importance of tighter liquidity conditions.
“Fundamental issues are easier to hide when liquidity is flooding into markets, and it is not anymore,” the analysts said.
And looking ahead, Morgan Stanley expects the withdrawal of global liquidity to accelerate in 2019, and the same time as US economic growth is slowing.
“As that happens, late cycle risks may morph into end-of-cycle fears,” they said. And in turn, the more leveraged parts of corporate bond markets will be left more exposed.
Importantly, the analysts noted that credit cycles don’t turn at a specific point in time, but in stages over a period of years.
But as financial conditions tighten, “idiosyncratic risks are rising”, and the process still has a long way to run.
At the same time, markets are starting to become more wary of credit risks, and valuations aren’t as extreme following the recent rise in yields — both factors which “should help at the margin”.
“That said, we very much stick to our bigger picture view that the credit bear market is under way,” Morgan Stanley said.
This table summarises the bank’s forecasts for US credit markets in 2019:
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