FOMO rally for world’s worst-rated bonds comes to an abrupt end

A feel-good rally that dragged down borrowing costs for the world’s worst rated bonds to a four-month low has come to an abrupt end.

Bonds rated CCC — the lowest tier of junk, issued by companies including Carvana and Altice France Holding SA — lost 0.86% in the June 19-23 period, the biggest slump since the March banking crisis. It’s a painful reversal for investors who made outsized gains this year by taking more risk.

“Investors were believing in a Narnia world where central banks tightened enough to crush inflation but not to hurt growth,” said Adam Darling, a fixed-income investment manager at Jupiter Asset Management. “That’s nonsense and it’s never been done before. The only way to get rid of this kind of inflation is recession.”

Bullish bets on high-yield corporate bonds started to unravel last week after Federal Reserve Chairman Jerome Powell reminded investors that getting inflation under control is the central bank’s top priority. The lowest-quality companies are the most exposed to downgrade and default as funding costs rise and earnings decline.

This year’s CCC rally was built on a belief that unemployment remains low and a recession may not actually happen. This month’s Fed pause on hiking interest rates added fuel, as did widespread fear of missing out.

“It was a lot about people being caught offside, worrying they were under-risked into a rally and then chasing it,” said Christian Hoffmann, a portfolio manager at Thornburg Investment Management. “It’s mostly been risk rallies where people participated in them begrudgingly and they were broadly-hated.”

Being underweight CCC risk would have caused bond portfolio managers to underperform, according to Oleg Melentyev, a credit strategist at Bank of America Corp.

“Investors can’t afford to do that, so they added risk in very liquid capital structures because they didn’t have conviction that it would last,” Melentyev added. “You take some risk with the assumption that you’re going to jump as soon as the tide turns.”

And just as a handful of artificial intelligence names have propelled stock markets, about 10% of CCC index companies account for half of the year’s gains, data compiled by Bloomberg show. They include AMC Entertainment Holdings, Norwegian Cruise Line Holdings and Douglas GmbH.

“What that shows is a lack of conviction on the part of the investors,” said Melentyev.

Spokespeople for Altice, Norwegian Cruise Line, AMC and Carvana did not respond to requests for comment. A representative for Douglas declined to comment.

Among those who missed most of the CCC rally was Al Cattermole, a senior credit analyst and portfolio manager at Mirabaud Asset Management. He reduced CCCs late last year to focus on the safest part of the junk market and expects the economy to slow by the fourth quarter.

“You’re not getting paid to have a massive correction in CCCs,” said Cattermole, adding that a decline in the junkiest bonds would mean a performance hit of several percentage points. “I’d rather be wrong in BBs than be wrong in CCCs,” he said, referring to higher-rated bonds.

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