Investor Appetite for Risk Persists Amid Recession Fears and Potential Rate Hikes

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Despite looming fears of a possible recession and potential interest rate hikes by the Federal Reserve, investors continue to demonstrate a taste for risk. The two largest U.S. junk-bond exchange-traded funds, iShares iBoxx $ High Yield Corporate Bond ETF HYG and SPDR Bloomberg High Yield Bond ETF JNK, each saw approximately 0.2% gains on Friday, following an indication from the Fed on Wednesday that it could maintain its policy rate above 5% longer than previously expected.

On the same day, major indices including the S&P 500 and the Nasdaq Composite Index also posted gains, increasing by 0.2% and 0.4% respectively, while the Dow Jones Industrial Average remained mostly static. High-yield bonds, colloquially known as "junk bonds," typically offer investors higher returns than investment-grade bonds due to their lower ratings and increased risks.

This risk appetite is reflected in a closely monitored credit-market indicator, The ICE BofA High Yield Index Option-Adjusted Spread, which measures the premium investors receive for investing in high-risk corporate bonds over U.S. Treasury bonds. On Thursday, it stood at 389 basis points above the risk-free rate.

This index had spiked to over 2,000 basis points above the benchmark during the 2008 financial crisis and rose nearly 1,100 basis points above Treasurys amid the COVID-19 outbreak in the U.S. in 2020. The current narrow credit spreads suggest investor optimism for a soft economic landing where inflation cools down and the economy avoids a recession, according to William Merz, head of capital market research at US Bank.

Merz's team continues to recommend a "normal" exposure to high-yield bonds, typically between 3% and 5% of a portfolio. They believe that until credit spreads begin to widen, indicating potential downside risks, it is reasonable to continue earning from the current income provided by high-yield bonds.

The near-record low credit spreads could also be partially attributed to the supply and demand dynamics of corporate bonds, as per Thomas Urano, co-chief investment officer at Sage Advisory. Investment-grade bonds are currently yielding around 5.9%, which may appeal to buyers less sensitive to spreads. The 10-year Treasury rate's sharp rise to 4.479% last Thursday, its highest since October 2007, contributes significantly to this yield.

Foreign investors have shown increased activity in the corporate space this year, noted Urano. He believes that if the present dynamic continues without a sudden downturn in the U.S. economy, the corporate sector could see tighter spreads. However, if the economy continues to slow into 2024, investors might start factoring in recessions, which could put pressure on credit spreads.

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