Betting on economic slowdown! Investors are heavily shorting high-priced corporate bonds

Faced with the extremely optimistic pricing in the corporate bond market, global investors are turning the tide.

According to a Reuters report on August 11, the latest dynamics and research from multiple global asset management companies and top banks show that investors are actively exiting or establishing short positions against high-priced corporate bonds. Mike Riddell, Chief Portfolio Manager of Strategic Bond Strategy at Fidelity International, stated that his team “has become very defensive in developed market credit,” having not only liquidated their exposure to cash bonds but also shorting high-yield bonds.

Behind this defensive move is the fact that corporate bond spreads have narrowed to historically extreme levels. Analysis shows that the key indicator measuring the premium of corporate bonds relative to government bonds—the investment-grade bond spread—fell to 78 basis points last Friday, just a step away from the 27-year low of 27 basis points set in 1998. This pricing level reflects the market's extreme optimism about the economy, sharply contrasting with the forecasts of most official institutions.

More importantly, hedging demand is surging. Stuart Kaiser, Head of U.S. Options Strategy at Citigroup, pointed out that his derivatives trading department has observed a significant increase in client demand for options products to short corporate bond indices in recent weeks. He believes this indicates that investors “see reasonable downside potential in the stock market over the next three months,” as historically, movements in the credit market often serve as leading indicators for the stock market.

Pricing Discrepancy: Divergence Between Credit Market and Economic Reality

UBS strategist Matthew Mish noted in a client report that the current level of credit spreads implies expectations of nearly 5% growth for the global economy, which is significantly higher than the 3% forecast by the International Monetary Fund (IMF).

This optimistic sentiment has left some investors uneasy. Van Luu, Head of Global Fixed Income and Currency Strategy at Russell Investments, stated that he believes this pricing is inaccurate and has therefore adopted an underweight strategy on credit. According to the IMF's forecast, the probability of the U.S. entering a recession this year is 40%, and other major economies also face risks. Matthew Mish bluntly stated that among many risk assets, “the credit market is an outlier (overpriced).”

Meanwhile, although the recession probabilities reflected in the stock and corporate bond markets are only in single digits, the U.S. Treasury market is sending a starkly different signal, betting that the Federal Reserve may cut rates up to three times in the coming months, indicating deep concerns about the economic outlook.

Leading Indicator: Surge in Hedging Demand Signals Market Shift

Historically, the credit market has often played the role of a “whistleblower” for the broader market. Whether during the trade disputes in 2018, the rate hike shocks in 2022, or the market turmoil at the end of 2023, ETFs tracking high-grade corporate credit have consistently declined ahead of the global stock market.

Now, warning signals are emerging again. Florian Ielpo, Head of Multi-Asset at Lombard Odier Investment Managers, found through analysis that the proportion of corporate bonds with narrowing spreads has dropped sharply from 80% to 60% over the five trading days ending August 4 He referred to it as "a significant change that cannot be ignored."

Stuart Kaiser from Citigroup also confirmed that macro investors may be "taking directional views or hedging against the rise of risk assets." This hedging behavior against credit risk itself indicates that market sentiment may be reversing.

High-Yield Bonds in Focus, Stock Market May Be Affected

In the high-priced corporate bond market, high-yield (or "junk") bonds are considered the most vulnerable link. Guy Stear, head of developed markets strategy at Amundi Investment Institute, stated that the high-yield bond market is most likely to see adjustments first, which will transmit to the stock market.

He expects that as early as October this year, due to cost increases from tariffs or cash flow pressures, the refinancing costs and default rates of high-yield bonds may surge, triggering widespread anxiety in the market regarding employment, investment, and growth. Currently, the premium that U.S. junk bond issuers need to pay relative to investment-grade companies has dropped to its lowest level since 2020, around 2.8%, indicating that market risk premiums have been severely compressed.

Stear emphasized, "When the credit market is under pressure, the stock market will ultimately also be under pressure."

However, not all market participants hold a pessimistic view. An article from Wall Street Journal noted that recently, the Nasdaq 100 index recorded its largest weekly gain in over a month. Winnie Cisar, global strategy head at CreditSights Inc., pointed out that strong technicals, ample policy space expectations, and better-than-expected earnings have collectively supported risk assets. However, market strategist Matt Maley believes that when the stock market and bond market diverge, "from an economic perspective, the bond market is almost always the correct side."