In this surging market, big institutions have started to pull out, and are even shorting?

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According to media reports on Monday, major asset management companies including BlackRock, Fidelity International, and M&G are cutting their exposure to high-risk corporate bonds. They are betting that after years of strong growth in this market, a global economic downturn could trigger a sell-off. These institutions have now shifted to safer, higher-rated corporate bonds or government bonds.

The spread between U.S. and European investment-grade bonds and government bonds is currently about 0.8 percentage points, a sharp narrowing from over 1.5 percentage points in 2022, nearing the lowest level since the 2008 global financial crisis.

This “endless narrowing” has prompted BlackRock, the world’s largest asset manager, to shift toward higher-rated and shorter-maturity bonds. Fidelity International, meanwhile, holds short positions on developed market credit in its global flexible bond fund, meaning it will benefit if spreads widen.

Some investors worry that the current rally, driven by eased trade tensions and expectations for Fed rate cuts, has led the credit market to price in global economic growth too optimistically. Recently, spreads have begun to widen slightly. Renewed trade tensions and anxiety sparked by the bankruptcy of auto parts supplier First Brands Group are eroding investor optimism. Some leveraged loan deals have been put on hold, and some hedge funds are beginning to avoid weaker corporate debt.

Spreads Narrow to Extreme Levels

Mike Riddell, a Fidelity International fund manager, warned:

Credit spreads are so narrow, there is almost no room left for further narrowing. If anything goes wrong in the world, spreads could widen significantly.

Simon Blundell, BlackRock's co-head of European active fixed income, pointed out that the market is "now pricing in a 'Goldilocks scenario' of rate cuts and stable US economic growth," and that this "risk/reward profile undoubtedly suits a defensive stance in the credit market." In some cases, credit spreads—as a proxy for investor risk assessment of borrowers—have even turned negative.

The market expects the Fed to cut rates by at least four more 25-basis-point moves by the end of next year, and with corporate balance sheets strengthened in recent years, optimists believe the ultra-narrow spreads are reasonable.

High-Risk Areas Facing Headwinds

Segments of the corporate bond market with higher risks have shown signs of investor resistance. In recent weeks, multiple leveraged loan deals—including a $5.8 billion issuance by specialty chemicals producer Nouryon and a deal worth over $1 billion by pharmaceutical company Mallinckrodt—have been put on hold. Meanwhile, prices of some outstanding loans are falling as investors turn to safer debt.

A high-yield bond trader commented:

There have been quite a few blowups in the past week or two, which is shaking confidence.

Andrea Seminara, founder and chief investment officer of London credit hedge fund Redhedge, said that not only is the corporate credit market too tight, but the spreads between different companies are likewise tight. The market is not pricing in a lot of idiosyncratic risk at all. Some hedge funds are now avoiding weaker corporate debt to respond to what they see as indiscriminate spread tightening this year.

Shifting to Defensive Allocations

Paul Niven, manager of the £6.4 billion F&C Investment Trust, said the fund has cut its credit positions to “neutral” in recent weeks, selling high-yield bonds because the asymmetric cost relative to government bonds is becoming increasingly expensive.

Ben Lord, fund manager at M&G Investments, said that yields on corporate bonds are attractive and worth holding now. However, he added that the firm is shifting into higher-rated corporate credit and areas such as secured bonds issued by life insurers. The cost of selling BBB-rated unsecured bonds and buying these has fallen to its lowest level in years.

Due to government bond yields having risen in recent years, overall returns from corporate bonds—i.e., “all-in yields”—are still seen by many as attractive. According to the ICE index, the yield to maturity on U.S. investment-grade bonds is about 4.8%.

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