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Junk bonds — no longer 2018’s darling — flip to red as the corporate debt climate deteriorates

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Amid a chorus of concerns over corporate debt, a key index for the high-yield bond market has turned negative this year, losing its status as one of the last corners of Wall Street to carry positive returns in 2018.

Resilient to the Federal Reserve’s rate hikes and stock market turmoil, high-yield debt finally succumbed to slumping oil prices and mounting fears over the sustainability of hefty debt loads among corporations. Issuers of high-yield corporate bonds, or junk debt, are rated below investment-grade by credit ratings firms due to their weaker balance sheets. They typically reward investors with higher yields for taking on added risk.

“The selloff in energy prices that picked up last week, coupled with worries about credit in general, built up last week such that the ‘risk off’ trade was alive and well,” wrote Jody Lurie, corporate credit analyst at Janney Montgomery Scott.

The Bloomberg Barclays U.S. High-Yield Corporate Bond index was down 0.1% year-to-date last Friday. As high-yield debt prices have taken a beating, yields have risen, raising the compensation investors paid to own the basket of high-yield bonds over Treasurys, or the credit spread, to 412 basis points, its widest levels since December 2016.

More liquid exchange-traded funds specializing in high-yield debt showed heftier losses, with the SPDR Bloomberg Barclays High Yield ETF JNK, +0.06%   down 5.9% and the iShares iBoxx $ High Yield Corporate Bond ETF HYG, -0.31%   down 4.8%, FactSet data shows.

But only a month ago, high-yield debt investors were sitting on relatively fat returns. In the year to date through Oct. 3, Bloomberg’s high-yield index was on track for a 2.8% annual return. The yield premium investors paid to own a basket of high-yield bonds over Treasurys, or the credit spread, stood at 3.03 percentage points, its tightest level in 11 years.

Those returns quickly slipped away with oil’s descent as crude slipped into a bear market, defined as a drop of at least 20% from a recent peak. Crude CLZ8, +1.26%   is trading at $55.76 a barrel, a sharp drop from its nearly four-year high of $76 in early October.

Analysts often link the ups and downs of energy prices closely to the fortunes of the high-yield debt market because energy-related issuers make up 15% of the index.

And investing luminaries like Paul Tudor Jones of hedge fund Tudor Investment Corporation and Scott Minerd of Guggenheim Partners have recently voiced concerns over the pent-up risks in the corporate debt market as the Federal Reserve steadily raises interest rates.

Contributing to those fears, a selloff in General Electric’s GE, +0.26%  corporate bonds drew talk of credit ratings firms pushing the investment-grade behemoth into junk territory, becoming a so-called fallen angel.

In the last few weeks, the U.S. manufacturing giant dropped to BBB after downgrades by Moody’s and Fitch to join a ballooning tranche of debt that represents around half of the entire investment-grade market. BBB-rated bonds sit three to one rungs above high-yield.

If a wave of downgrades plunges such bonds into junk, analysts say conservative investors like insurance companies and pension funds restricted to holding investment-grade paper would have to dump these fallen angels, overwhelming high-yield bond buyers.

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Updates to our Distressed Debt 1 Hedge Fund



Updates to our Fixed Income 2 (FX2) Segregated accounts

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