Credit traders rush to hedge on US economic fears

(Bloomberg) — Bond investors are buying insurance against defaults on corporate bonds as concerns grow about the health of the U.S. economy and European consumers.

The cost of protecting a basket of high-quality North American credits from default rose by the most since October on Friday. Trading volumes on that credit default swap index, CDX.NA.IG, hit their highest daily level in about five months on Friday, according to data compiled by Bloomberg. The European counterpart had its busiest day this week since French President Emmanuel Macron announced a surprise election in June.

Credit derivatives are often the first instruments to show signs of weakness in a market downturn, in part because it can take longer to sell bonds. Traders stepped up purchases of the security after a series of weak jobs data raised concerns that the Federal Reserve had waited too long to cut interest rates.

Fund managers are also concerned about disappointing results for technology companies and a reduction in consumer spending on everything from fast food to luxury handbags.

“Weaker macro and the impact on future earnings is the only underappreciated risk in markets in our view,” said Raphael Thuin, head of equity strategy at Tikehau Capital. “This could weigh on credit spreads at a time when valuations are far from cheap.”

Bond spreads are likely to widen because they currently trade in a tight range that has been justified by factors such as interest rate cut expectations and the fact that buyers are paying more attention to absolute yields than relative valuations, said Srikanth Sankaran, head of European credit strategy at Citigroup Inc.

In the same region, JPMorgan Chase & Co. strategists “recommend setting up cheap hedges” through the investment-grade iTraxx Europe credit default swap index, arguing that “earnings season is off to a rocky start.” BNP Paribas SA’s credit strategy unit suggests betting on widening spreads through a CDS index tracking older financial issuers.

Even with the increase in volumes, the iTraxx Europe index is trading around 63 basis points, much closer to multi-year lows than the triple-digit levels seen in 2022 and 2023. The CDX.NA.IG index is up around 58 basis points, its highest since January, but still below its five-year average.

In response to market concerns about economic weakness, investors are now pricing in more than a percentage point of Fed rate cuts this year, and by the end of the week, the U.S. stock market had posted its worst two-day decline since March 2023. Central bank officials had previously predicted a single rate cut in 2024, according to a median forecast released in June.

That comes as U.S. companies are on track to post their weakest combined earnings, beating forecasts, since the fourth quarter of 2022. Sales among European companies that reported second-quarter earnings were about 1.2% below analysts’ expectations, according to data compiled by Bloomberg.

“There’s a cyclical theme to this that wasn’t there before. It illustrates that the risk balance is probably shifting from ‘too hot, rates higher’ to ‘too cold, rates lower,’” said Viktor Hjort, global head of credit strategy and desk analyst at BNP Paribas. He said the market is now between two states.

Despite concerns, some bond buyers, especially those driven by yields, will continue to bid up the loans. This demand means it could be a while before weakness shows up in the corporate bond market, but even before that happens, the CDS market is where the cracks will appear.

When volatility spikes, “usually people hedge by using a liquid CDS index and then sell their bonds later,” said Matt King, founder of research firm Satori Insights. “Usually what forces the cash index to move is people starting to have significant outflows,” and “based on the global numbers, I don’t think that’s happened yet, but it will be a significant risk.”

–With assistance from Dan Wilchins.

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