In this surging market, large institutions are starting to withdraw, and even short selling?

According to media reports on Thursday, large asset management companies including BlackRock, Fidelity International, and M&G are reducing their exposure to high-risk corporate bonds, betting that this market, after years of strong growth, will face selling risks if the global economy weakens. These institutions have turned to safer, higher-rated corporate bonds or government bonds.

The spread of U.S. and European investment-grade bonds relative to government bonds is currently about 0.8 percentage points, significantly narrowing from over 1.5 percentage points in 2022, approaching the lowest level since the 2008 global financial crisis.

This "endless narrowing" has prompted the world's largest asset management company, BlackRock, to shift towards higher-rated and shorter-term bonds. Fidelity International, on the other hand, holds short positions in developed market credit within its global flexible bond fund, meaning it will benefit if spreads widen.

Some investors are concerned that the recent rally, driven by easing trade tensions and expectations of interest rate cuts by the Federal Reserve, has led the credit market to price in global economic growth too optimistically. Recently, spreads have slightly widened, and renewed trade tensions, along with the bankruptcy of auto parts supplier First Brands Group, are undermining investor optimism. Some leveraged loan deals have been shelved, and some hedge funds are beginning to avoid weak corporate debt.

Spreads Narrowed to Extreme Levels

Fidelity International fund manager Mike Riddell warned:

Credit spreads are so narrow that there is almost no room for further narrowing. If any problems arise in the world, spreads could widen significantly.

Simon Blundell, co-head of European active fixed income at BlackRock, pointed out that the market is "now pricing in a 'golden girl scenario' of interest rate cuts and stable growth in the U.S. economy," and that this "risk/reward is undoubtedly suitable for taking a defensive stance in the credit market." In some cases, the credit spreads, which serve as indicators of investors' risk assessments of borrowers, have even turned negative.

The market expects the Federal Reserve to cut rates at least four more times by 25 basis points by the end of next year, and with corporate balance sheets having strengthened in recent years, optimists believe that the ultra-narrow spreads are justified.

High-Risk Areas Encounter Resistance

Signs of investor resistance have emerged in high-risk areas of the corporate bond market. In recent weeks, several leveraged loan deals, including a $5.8 billion issuance by specialty chemicals producer Nouryon and a transaction of over $1 billion by pharmaceutical company Mallinckrodt, have been shelved. Meanwhile, prices of some outstanding loans have fallen, and investors are opting for safer debt.

A high-yield bond trader stated:

There have been quite a few defaults in the past week or two, which is shaking confidence.

Andrea Seminara, founder and chief investment officer of London-based credit hedge fund Redhedge, stated that the corporate credit market is not only overly tight, but the spreads between companies are also similarly tight. The market is completely not pricing in a large number of specific risks. Some hedge funds are avoiding weak corporate debt to cope with what they perceive as indiscriminate narrowing of spreads this year

Shift to Defensive Allocation

Paul Niven, the fund manager of the F&C Investment Trust managing £6.4 billion, stated that the fund has reduced its credit bond positions to "neutral" in recent weeks, selling off high-yield bonds as the asymmetry of costs compared to government bonds has become increasingly expensive.

Ben Lord, a fund manager at M&G Investments, mentioned that corporate bond yields are attractive and worth holding now. However, he added that the company is shifting towards higher-rated corporate credit and areas such as guaranteed bonds issued by life insurance companies. The cost of selling BBB-rated unsecured bonds and buying these bonds is at its lowest level compared to the past.

Due to the rise in government bond yields in recent years, the overall yield (i.e., "full price yield") that investors receive from corporate bonds is still seen as attractive by many. According to the Ice index, the yield to maturity of U.S. investment-grade bonds is approximately 4.8%