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Global stock retreat dents sentiment on European junk bonds

Investor sentiment on European junk bonds, a key market risk barometer, has dimmed as volatility in global equities and rising tension on the Russia-Ukraine border prompts investors to ditch risky assets.

The spread on the iTraxx Crossover index, which measures the cost of hedging against junk-rated companies defaulting on their debt, rose as high as 295 basis points on Friday, a level not reached since November 2020. The spread has increased around 50 bps since the end of 2021.

The moves come as US officials warn there is a “distinct possibility” that Russia could within weeks invade Ukraine. Around 100,000 Russian troops are currently stationed close to the border.

For many investors, however, the risk of a land war erupting in eastern Europe pales in significance to the threat posed by runaway inflation.

US Federal Reserve chair Jay Powell on Wednesday stopped short of ruling out raising interest rates at each of the seven central bank meetings still to come this year. Markets are now pricing nearly five interest rate rises this year, when only one was expected in 2022 as recently as November.

“It shouldn’t be a major shock to see [the iTraxx] drifting wider, particularly in the last few days, on the back of the [US Federal Reserve’s] hawkish tilt,” said Fraser Lundie, head of credit at Hermes Investment Management.

High-yield assets tend to track other risky assets like equities, as well as broader volatility, Lundie said. The Vix index, sometimes referred to as Wall Street’s ‘fear gauge’, this week hit its highest point in more than a year.

Yet given the sharp sell-off in technology stocks in January, Lundie said he was surprised the iTraxx had not risen higher.

“I think that’s partly because the fundamental backdrop for high yield is really strong,” he said. “Default rates are on the floor, balance sheet health is good and earnings have been strong.”

“When equities move a lot it tends to have some contagion effect on non-investment grade credit”, said Gilles Dauphine, head of alpha euro fixed income at Amundi, who also expected a bigger iTraxx spike. The stand off between Russia and Ukraine “isn’t helping” investor sentiment, he added.

In the US, junk bonds sold off this week. The yield on a widely watched high-yield bond index run by Ice Data Services rose to 5.11 per cent on Thursday, its highest level since November 2020, as expectations of tighter monetary policy pushed the price of risky debt lower.

Robust economic growth, low defaults and wide open funding markets have helped support the market, preventing more intense pressure. “There is some confidence that the Fed will be able to thread the needle,” said Nichole Hammond, a portfolio manager at Angel Oak Capital Advisors.

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