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By WSJ 3.31.2019 • April 2, 2019

Debt Investors at a Crossroads as Fed Pivots

Investors piled into bonds in the first few months of 2019, buying everything from Treasurys to riskier corporate debt as a newly supportive Federal Reserve eased concerns about rising interest rates and the potential for a near-term recession.

Now, a sharp drop in Treasury yields has stirred a debate about whether to take heart from the Fed’s pivot or be wary of the potentially troubling causes that prompted the central bank’s shift.

As of Friday, the closely watched yield on the 10-year U.S. Treasury note, which falls when bond prices rise, stood at 2.416%. That was down from 2.684% at the end of last year and 3.23% in early November. Before Friday, when the yield on the three-month Treasury bill settled at 2.396%, the 10-year yield had spent five sessions below that of the three-month bill, the first time that had happened for any amount of time since 2007.

That so-called inversion of the yield curve generally signals falling growth expectations and often precedes recessions.

“I think we’re at a pretty interesting inflection point,” said Priya Misra, head of global rates strategy at TD Securities in New York. The Fed, she said, has either extended the economic expansion, in which case investors can keep buying, or it has sent a “signal that the end of the cycle is upon us,” in which case investors should be rushing into government debt.

Even as Treasurys have rallied recently, corporate bonds have largely kept pace, indicating investors aren’t overly worried about the economic outlook.

As of Thursday, the extra yield that investors demand to hold speculative-grade bonds over U.S. Treasurys stood at 4.02 percentage points, down from 5.26 percentage points at the end of 2018.

For the most part, conditions have been favorable for U.S. corporate borrowers this year. After Fed Chairman Jerome Powell persuaded investors in early January that the central bank might significantly rein in its pace of rate increases, companies this year have sold $138 billion of speculative-grade corporate bonds and loans in the U.S. market, according to LCD, a unit of S&P Global Market Intelligence.

That is up from just $4 billion in December and $25 billion in November, when there were widespread concerns that the Fed might continue to raise rates about once every quarter.

Briefly after the Fed’s March policy meeting, it appeared conditions were only improving for investors and borrowers. Fed officials confirmed they no longer planned to raise rates in the near future, other major threats to bonds were muted: Inflation remained benign and the U.S. economy was neither hot enough that investors might dump bonds for stocks nor cold enough to pose a serious threat to the financial stability of most corporate borrowers.

Then, two days later, a batch of dreadful economic data out of Europe showed a deepening contraction in that region’s manufacturing sector. That prompted the 10-year Treasury yield to drop below the 3-month yield and rekindled concerns about global growth that contributed to overall market tumult in the fourth quarter.

Some investors now worry that the current bond rally is based on unsteady foundations. It is unclear whether strong demand for corporate debt this year has been driven by confidence in the U.S. economy or a more knee-jerk, and potentially risky, reach for yield as underlying Treasury rates have fallen.

Investors have some good reasons for buying corporate bonds. But “my biggest concern is that it’s mostly a yield grab,” said Scott Kimball, a portfolio manager at BMO Fixed Income.   

Still, many investors, including Mr. Kimball, don’t see the economic situation as that dire. Despite the troubling weakness in the European manufacturing sector, Europe generally still has a tight labor market, a reasonably strong service sector and a very supportive central bank, said Julien Scholnick, a portfolio manager at Western Asset Management. Growth in the U.S., meanwhile, is widely expected to speed up over the next three months after a slow start to the year.

Mr. Scholnick said his team added riskier assets to its bond portfolios at the end of 2018 and start of 2019 and hadn’t made any major adjustments since the release of the eurozone manufacturing numbers.


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