Fed's Big Rate Cut Sparks Valuation Anxiety, Investors Flock to Corporate Bonds

Investors are pouring substantial funds into corporate debt, with risk premiums gradually tightening, and the Federal Reserve's interest rate cuts have reignited hopes that the U.S. can avoid a recession. In the meantime, some fund managers have indicated that the market is currently overly complacent about factors that warrant concern.

Simon Matthews, Senior Portfolio Manager at Neuberger Berman, stated, "The U.S. election is approaching, expectations for German economic growth are the weakest since before the COVID-19 pandemic, consumers are feeling pinched, and China's economic growth is slowing down. When you consider all these factors together, it does not suggest that credit spreads should be near their upper limits." He added that the decline in borrowing costs will help mitigate some adverse factors.

Investors have been shelving potential negative factors and delving into the riskiest credit areas in search of higher yields. The lowest-rated bonds are currently outperforming the overall junk bond market, and demand for Additional Tier 1 bonds, which may force investors to incur losses to help banks weather turbulence, is expected to increase.

Buyers are betting that lower borrowing costs will allow debt-laden companies to refinance and defer maturities, thereby limiting defaults and supporting valuations. As short-term interest rates decline, investors are expected to shift their allocations from money markets to medium to long-term corporate debt, which could lead to further narrowing of spreads.

However, Hunter Hayes, Chief Investment Officer at Intrepid Capital Management, said that if consumers start increasing spending as interest rates are lowered, inflation may start to rise again. He said, "Who knows, maybe the federal funds rate will return to levels seen in previous inflationary cycles, and then suddenly, the appeal of high-yield bonds will be greatly diminished."

Amanda Lynam and Dominique Bly, researchers at BlackRock, wrote in a report that due to the U.S. monetary policy likely remaining restrictive, market participants are also watching for signs of deteriorating fundamentals, especially among borrowers holding floating-rate bonds. Additionally, issuers rated CCC are still under pressure overall, despite their bonds' recent strong performance.

They noted that these companies' overall profitability is low compared to their interest expenses. The borrowing costs for CCC-rated companies are still around 10%, which is a heavy blow for some small companies that must refinance after the era of easy money ends, and they still face the risk of default even if interest rates decline.

Analysts at J.P. Morgan, including Eric Beinstein and Nathaniel Rosenbaum, wrote in a research report last week that any weakness in the labor market will also be "detrimental to spreads, as it will increase concerns about a recession and reduce yields."

It is certain that valuation concerns remain mild, and investors have largely increased their holdings of corporate debt. Analysts at BNP Paribas wrote in a report that the beginning of the interest rate cut cycle is expected to be more supportive of demand for non-cyclical bonds in the investment-grade market than cyclical bonds.

They added that the limited issuance from healthcare companies and utilities provides room for spread compression.The head of U.S. credit strategy at the firm, Meghan Robson, said in an interview: "This is a great opportunity for non-cyclical investors to outperform the market, while cyclical bonds are overvalued."