Asset managers with money to spend and few new deals to buy have pushed credit spreads to near all-time tights as the global economy remains strong. That’s a signal for some that it’s time to buy downside protection.
Corporate bond shorts have risen 25% to almost US$336 billion ($452.46 billion) in the past year compared with a rise of 10.6% in institutional longs to US$4.6 trillion, according to data compiled by S&P Global Market Intelligence. Wagers that prices will fall now stand at the equivalent of 7.3% of longs, up from 6.4% a year ago, based on securities borrowing.
The rise in shorts comes as a gauge of complacency reaches the highest level since 2021, the amount of distressed debt falls to the lowest this year and US economic growth continues to confound sceptics. But expectations that incoming President Donald Trump’s policies on tariffs and immigration will boost inflation worry economists, leading some fund overseers to hedge their bets.
“Large inflows into high-yield bond funds in the US and Europe are causing spreads to grind tighter. If valuations are screening extremely tight, shorting bonds can be highly profitable and hedge funds running quantitative strategies will use all these valuation metrics,” said Zachary Swabe, a high-yield portfolio manager at UBS Asset Management.
Any “deterioration in the macro outlook will also give funds a fair reason to short securities,” he said.
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There are reasons for concern. US fiscal policy is on an “unsustainable path,” according to economists at Apollo Global Management, S&P 500 earnings misses are on the increase and funding costs in overnight repo markets are rising at a concerning rate. Adding to the woes, Germany’s economy has been moribund and China has yet to see a broader pickup in growth after a wave of stimulus.
Despite the warning signs, spreads in US junk bonds now stand about 30 basis points above their all-time lows, set before the global financial crisis. And while risk premiums in Europe have further to go until they reach rock bottom, they have fallen well below their historical average.
Hedging strategy
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Investors may also be shorting corporate credit as part of a broader hedging strategy to offset long positions in equities or other assets that may be sensitive to debt conditions, according to S&P Global Market Intelligence director Matthew Chessum.
Market makers at banks are also borrowing bonds to sell to asset managers who are trying to put new money to work, leaving dealers effectively short until they can actually buy the debt, according to two people with knowledge of the matter.
If they didn’t do so, banks would have been unable to tackle large buy orders by funds in recent months as bank inventories have shrunk due to post-crisis regulations, the people said, asking not to be identified as they aren’t authorised to speak publicly.
Still, hesitancy about the state of the market can also be seen beyond the short data. Credit-default swap indexes covering a basket of junk-rated companies in Europe and North America have not tightened as much as the spreads of bonds they insure against.
Shorting the securities will pay off if the economic picture suddenly darkens. Credit strategists at JPMorgan Chase & Co. told clients recently that “we are potentially on the precipice of a global trade war with spreads already at tight levels.”
Morgan Stanley strategists, meanwhile, warned this past week that the performance of corporate credit is set to weaken in the second half of next year as “animal spirits” grow and “take hold.”
What to watch
- About US$15 billion to US$20 billion of US high-grade bond sales are expected in the coming Thanksgiving holiday week.
- In Europe, 50% of professionals surveyed expect €10 billion ($14.04 billion) to €15 billion of sales next week, with the rest evenly split between expectations above or below that.
- In the US, the Federal Reserve on Nov. 26 will release minutes from the Nov. 6-7 FOMC meeting.
- Bloomberg Economics forecasts that the core PCE deflator — the Federal Reserve’s preferred inflation gauge — rose 0.28% month over month in October. Data due Nov 27.
- Canada’s GDP due Nov. 29 likely grew at an annualized pace of 1.9% in the third quarter, slightly slower than 2.1% in the second, according to Bloomberg Economics.
- Bloomberg Economics expects the flash November euro-area inflation reading on Nov. 29 to tick up to 2.2% year on year, from 2.0% in October.
