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Some of debt’s 2022 losses are erased on potential for interest rates to top out without forcing defaults

Investors are driving a modest end-of-year rally in junk bonds, erasing some of 2022’s biting losses in a bet that the economic outlook for next year has stabilized.

Yields on below-investment-grade corporate bonds tracked by Intercontinental Exchange’s index have declined to 8.8% through Tuesday’s trading, down from a recent high of 9.61% on Oct. 13. Investors say they are growing more confident that interest rates might peak without putting many lower-rated companies’ ability to repay debt in serious jeopardy.

Bonds across the board have been slammed this year by the Federal Reserve’s efforts to contain inflation, which has fueled the steepest series of interest-rate increases in decades. Inflation and higher rates undercut the value of bonds’ fixed stream of payments to investors, sending bond prices lower and yields higher.

Adding to the suffering for junk-rated bonds have been fears that higher rates could bring an economic slowdown that would hurt debt-laden businesses’ ability to make payments on time, raising the possibility of defaults.

In the past month, fresh data and comments from Fed officials have convinced many investors that the end of rate increases could be in sight. Figures showing that year-over-year inflation slowed to 7.7% in October from 8.2% in September, “were a welcome relief,” Dallas Fed President Lorie Logan said after their release.

At the central bank’s November meeting, officials “were increasingly focused on the question of when the Committee might slow the pace of future increases,” according to the meeting’s minutes, referring to the rate-setting Federal Open Market Committee.

Meanwhile, rising rates haven’t dimmed the outlook for corporate profitability as much as some investors had feared. While more companies are laying off workers and cutting their forward guidance as demand slows, Wall Street analysts still expect corporate earnings among S&P 500 companies to grow 6% this year and another 6% next year, according to FactSet.

“Despite the fact that we think we’re going into a recession in 2023, corporate balance sheets are in pretty good condition,” said John McClain, a portfolio manager at Brandywine Global Investment Management. “We don’t see a meaningful default cycle going into 2023 and beyond.”

Those factors have helped draw a steady stream of cash into junk-bond funds in the past month. Funds of sub-investment-grade debt have drawn positive net inflows for five straight weeks through Nov. 23, adding a total of $13.47 billion during that stretch, according to Refinitiv Lipper. That marks the largest sustained run of inflows this year by far.

More companies in addition are paying down debt, a positive signal for junk-bond investors who scrutinize balance sheets to determine how likely businesses are to pay back debt on time.

Last week the junk-rated clothing retailer Abercrombie & Fitch ANF -0.11% said it bought back $8 million of its own debt in the third quarter, alongside $8 million of share repurchases. In October, Joel Ackerman, chief financial officer of the dialysis provider DaVita Inc., DVA +1.76% told analysts on a conference call that the company would focus more of its capital deployment on lowering its debt level.

With higher financing costs putting corporate deal making and fundraising on hiatus, a dearth of new issuance has supported junk-bond prices this year. At barely more than $100 billion in 2022, junk-bond issuance is on track to fall by more than 78% compared with last year, according to Leveraged Commentary & Data.

Despite the recent rally, junk bonds have still handed investors losses on the year, returning minus 11% in 2022 including price changes and interest payments, according to ICE’s indexes. That is still better than the minus 16% returns on higher-rated corporate debt.

High-yield bonds have outperformed others largely because, in addition to offering higher interest payments, they tend to come due more quickly than their investment-grade counterparts, said Steven Foresti, chief investment officer for asset allocation and research at Wilshire Advisors. That means their prices are liable to fall less when interest rates rise.

Mr. Foresti has been telling clients that, at yields near 9%, junk bonds are offering attractive value. “There is much more utility to these investments than there was even less than a year ago,” he said.

Others are skeptical. In the midst of the recent rally, junk bonds are offering 4.63 percentage points more yield than Treasurys, down from nearly 6 percentage points in June. During past recessions, that premium, or spread, has often climbed above 8 percentage points as investors demand higher compensation for rising risk of default.

Now, with many investors confident that a recession is on the way, junk-bond spreads aren’t high enough to make the risks worthwhile for investors, said Saurabh Sud, a portfolio manager at T. Rowe Price.

Just as the Fed was late to respond to inflation’s rise in 2021, the central bank might be slow to ease off as the economy cools, he warned, a gloomy prospect for highly indebted companies.

“If that creates an environment where the risk of overtightening is high, what that implies is that the risk of an accident in credit is high,” Mr. Sud said.

Rescue of failed energy supplier has ballooned, with taxpayers on hook for potentially hundreds of pounds per household

The High Court has ruled that the UK government’s plan to sell bailed-out energy supplier Bulb to Octopus can proceed, despite challenges from rivals ScottishPower, Eon and British Gas owner Centrica.

But opponents to the deal could still apply for a court order to suspend the transfer of Bulb’s 1.5mn customers to Octopus ahead of a potential judicial review. The transfer is set to take effect on December 20.

Centrica, Eon and ScottishPower, which have criticised the opacity and the speed of the sale, this week confirmed that they had lodged judicial reviews of the government’s decision in October to approve the rescue deal, the biggest state bailout since the financial crisis.

Centrica has claimed in court documents that the deal poses a threat to the stability of the energy sector and disclosed that it had proposed to ministers an alternative plan, which it says would be better value for taxpayers.

The financial rescue of Bulb has ballooned, with taxpayers on the hook for potentially hundreds of pounds per household.

The total could exceed £200 per household if the final cost exceeds about £5.8bn, based on the number of UK homes. The Office for Budget Responsibility has estimated that the bill to the taxpayer will soar to £6.5bn.

The sale to fast-growing Octopus would create a challenger to British Gas and Eon as the merged company would become one of the biggest retail energy suppliers in the UK.

But the deal has become increasingly contentious, with the government declining to reveal the terms of the sale and rivals complaining that Octopus is probably receiving “state aid” to take on Bulb’s 1.5mn customers.

Octopus and Teneo, special administrator to Bulb, have argued that companies interested in buying the failed supplier could also have sought funding from the government during the lengthy sales process.

The legal battle has pitted the old guard against one of the most prominent new “challenger” energy companies.

Octopus was launched in 2016 by the technology entrepreneur Greg Jackson to break up the might of the “legacy” suppliers such as Centrica, which is led by Chris O’Shea, who has previously held senior roles at Shell and the former BG Group.

Bulb was placed into special administration in November 2021. Its effective nationalisation was supported initially with a £1.69bn loan, of which £1.14bn has so far been drawn down.

While the UK business department has argued that the final bailout total could be lower than the estimated £6.5bn by the OBR, without providing details why, almost every household is likely to be stung by higher energy bills next year as the costs associated with the Bulb rescue are transferred to consumer bills.

Court filings this week show that Centrica pitched a rival plan to the Treasury, proposing that Bulb’s customers be divided between “a group of energy suppliers who do not present financial viability risks”.

A break-up and division of Bulb’s customers across multiple suppliers would have involved a “concomitant reduction in the amount of state support that would be required” to successfully transfer Bulb out of special administration, Centrica argued in the documents.

Centrica claimed in court filings that Octopus’s support for allowing energy retailers to use customer credit balances to help finance their operations posed a risk to the industry.

Centrica has pushed regulator Ofgem to introduce ringfencing for customer balances, which are generally built up in the summer months to help smooth bills over the winter.

The level of government support that Octopus will receive to buy electricity and gas for Bulb’s former customers has not been disclosed but it was previously reported that the company had asked for £1bn, which would be repaid as customers pay their bills.

Octopus said the High Court’s decision on Wednesday to give the transfer a green light would save taxpayers “millions, even billions, of costs that could have been incurred if the process was dragged out”.

Eon said: “It’s important we shine a light on the exact terms of this deal.

“The British public deserves an honest explanation of where their money is going and how they might, in the future, get some of it back.”

Centrica and ScottishPower did not immediately respond to requests for comment.

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