TD Spots a Red Flag Not Seen Since 2007 Coming for the Corporate Bond Market

(Bloomberg) — Last month’s banking drama means a technical tidal wave may be coming for the biggest slice of the $10 trillion market for corporate bonds.

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That’s according to TD Securities, where analysts are predicting that banks’ collective higher cost of funding will curb appetite for higher-quality credit and eventually force a spike in risk premiums.

At issue are shrinking yields on investment-grade bonds relative to the effective federal funds rate, a proxy for funding costs. This “carry spread” has now reached levels seen only twice before in the past 27 years — the last time being in 2007.

That means that even though high-quality corporate bonds might look “cheap” based on their mark-to-market values, which have plummeted over the past year as interest rates spiked, the higher cost of funding these positions could still curtail bank purchases and eventually force a move higher in spreads.“The US recession we forecast in the final quarter of the year, along with the recent collapses of Silicon Valley Bank and Credit Suisse, has heightened the risk of a correction in the US investment-grade corporate bond market,” says Cristian Maggio, TD’s head of portfolio and ESG strategy. “Tighter lending conditions ahead may act as a catalyst for this correction.”

While banks aren’t the largest investors in the corporate bond market, they do play an important role in facilitating trades and providing liquidity for other investors. To do so, banks have to allocate precious regulatory capital and balance sheet — something which is becoming both more scarce and expensive in the aftermath of March’s banking collapses and a wider flight in deposits.

So even though banks own just 7% of outstanding corporate bonds, according to TD’s estimates, they could still drive a correction in credit risk premiums that are low by historical standards. Maggio estimates that carry spreads are now just 23 basis points, marking the third-tightest level in data that begins in 1996.

“Banks are important in this context as their sensitivity to interest rates may pressure US investment-grade corporate yields to correct,” Maggio says. “While unfunded investors (a large share of the market) may be content with a modest yield pick-up over Treasuries, liquidity providers need margins large enough to beat their internal funding costs.”“Against this backdrop, the widening of credit spreads we anticipate is necessary to rebalance the market and address pressure from the increasingly exhausted carry trade.”