Credit Traders Splash Out on Fears About the US Economy

A growing number of debt investors are taking precautions against corporate bond defaults, indicating growing worries about the state of the US and European consumer economies. The price of hedge against default on a portfolio of high-grade North American loans increased on Friday to levels not seen since October. According to Bloomberg statistics, trading volumes on the CDX.NA.IG credit default swap index hit their highest level every day in about five months. The day was the busiest for the European counterpart since June, when French President Emmanuel Macron announced an unexpected election.

Due in part to the extended duration of bond sales, credit derivatives frequently exhibit early warning indicators of market downturns. In response to dismal job market statistics, traders upped their protection buying, stoking worries that the Federal Reserve could have postponed interest rate reduction too long. Money managers were particularly unsettled by the lackluster profits from technological businesses and the decline in consumer spending on everything from fast food to high-end handbags.

Market Analysis and Reaction

“We believe that the underpriced risk in the markets is weaker macro and its impact on earnings in the future,” stated Raphael Thuin, Tikehau Capital’s head of capital market strategies. “Credit spreads may be impacted at a time when valuations are not at all cheap.”

Spreads on bonds seem ready to expand. According to Srikanth Sankaran, head of European credit strategy at Citigroup Inc., they are now at the tight end of a range that is supported by things like expectations for rate cuts and an emphasis on absolute yield levels rather than relative values.

Citing a poor start to the earnings season, analysts at JPMorgan Chase & Co. advise placing inexpensive hedges using the investment-grade iTraxx Europe credit default swap index in Europe. Using a CDS gauge that tracks senior financial issuers, the credit strategy department at BNP Paribas SA recommends placing bets on expanding spreads.

The iTraxx Europe index is trading at about 63 basis points, which is closer to multi-year lows than the triple-digit levels seen in 2022 and 2023, even with the increase in volumes. The CDX.NA.IG index is still below its five-year average even though it has risen to its highest position since January—roughly 58 basis points.

Market Implications and Economic Weakness

The greatest two-day decline in the US stock market since March 2023 is now being priced in by traders as a Fed rate decrease of more than a percentage point this year. As per the June-released median prediction, central bank officials had before predicted a solitary rate reduction in 2024.

The combined profits of US corporations are expected to surpass estimates for the first time since Q4 2022. According to Bloomberg statistics, sales at European businesses that have reported their second-quarter profits are around 1.2% lower than what experts had predicted.

It features a cyclical motif that has never been seen before. It shows that the risk-balance is likely moving from “too hot, rates higher” to “too cold, rates lower,” according to Viktor Hjort, BNP Paribas’ global head of credit strategy and desk analysts. As of right now, he says, the market is between these two states.

Dynamics of the Bond Market

Some yield-driven bond purchasers will persist in their credit bids despite apprehensions. Because of this demand, the corporate bond market may take some time to show signs of deterioration. But the CDS market is probably going to be the first to show signs of weakness.

According to Matt King, founder of researcher Satori Insights, “the usual effect is that people hedge using the liquid CDS index and then sell their bonds later” when volatility rises. Although there haven’t been any notable outflows as of yet, there is still a substantial risk, he said.

Review of the Week

• This summer has seen a significant increase in corporate borrowing on the US debt markets, which has encouraged money managers to remain active during the normally slow season.
• As the Federal Reserve gets closer to possible interest rate reduction, trade in corporate bonds is booming, pushing investors to lock in high returns.

US retailer J. Crew is considering refinancing a debt that it took out four years before to emerge from bankruptcy.

• Corporate governance changes have drawn credit investors and bolstered Japanese corporate dollar bonds, contributing to a near $2 trillion surge in Japanese equities.
• Because of high borrowing rates and declining real estate values, South Korean investors are pulling out of riskier loans for office buildings in Los Angeles and New York.
• Ares Management Corp. believes that even with anticipated rate reduction from the Federal Reserve, credit quality will hold up.
• Netflix Inc. saw orders for its maiden investment-grade bond issuance exceed $19 billion.
• To reduce the risk associated with sizable loan portfolios to private market funds, Morgan Stanley and Goldman Sachs are promoting bond offers.

In Motion

• The co-heads of Carlyle Group Inc.’s European buyout team, Marco De Benedetti and Jonathan Zafrani, are retiring. Michael Wand is going to be responsible for more.
• To strengthen its direct-lending team, Barings LLC has appointed Joseph Plank as managing director in its worldwide private finance group.
• Nikesh Parmar of RBC will take over as head of investment-grade credit trading at BNP Paribas SA, after the departure of Nabil Benjelloun.

Max Elliott-Taylor has been appointed by DWS Group, the asset management division of Deutsche Bank AG, to oversee CLO portfolios.

• To improve its debt capital markets offering to European financial institutions, Bank of Montreal has brought on Carole Ly-Marin and Matteo Segnalini as employees.
• Avner Husen, managing director of Blackstone Inc., has been hired by Farallon Capital Management to oversee US real estate credit.

This spike in hedging activity is indicative of rising concerns about the state of the US economy and how it could affect corporate bonds. Credit derivatives markets are expected to remain a reliable source of early warnings about market mood and economic trends as traders and investors negotiate these risks.