(Bloomberg) -- Investors are pouring money into corporate bonds, risk premiums are grinding tighter, and the Federal Reserve’s interest rate cut is reigniting hopes the US will dodge a recession.

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Some money managers say the market is too complacent about causes for concern now.

“You have the US election coming up, and expectations around economic growth in Germany are some of the weakest it’s been since pre-Covid times,” said Simon Matthews, a senior portfolio manager at Neuberger Berman. “Consumers are feeling the pinch and growth in China is slowing. When you pull that all together, it’s not telling you that credit spreads should be close to the tights,” he added, noting that falling borrowing costs will help reduce some of the headwinds.

Investors have been setting aside the potential negatives and diving deeper into the riskiest corners of credit in the hunt for higher yields. The lowest-rated bonds are now outperforming the broader junk bond market while demand for Additional Tier 1 bonds, which can force losses on investors to help a bank survive turmoil, is expected to increase.

Buyers are betting that lower borrowing costs will enable debt-laden companies to refinance and push out their maturities, limiting defaults and supporting valuations. And as short-term rates drop, investors are expected to shift their allocations into medium- and longer-term corporate debt from money markets which could cause spreads to tighten even further.

Still, inflation could start ticking up again if consumers start spending more as interest rates are cut, according to Hunter Hayes, chief investment officer at Intrepid Capital Management Inc.

“Who knows, maybe the Fed funds rate has to come right back up like it has in previous inflationary cycles and then, all of a sudden, high-yield bonds are a lot less attractive again,” he said.

With US monetary policy likely to remain restrictive, market participants are also watching for signs of deterioration in fundamentals, especially among borrowers exposed to floating-rate debt, BlackRock Inc. researchers Amanda Lynam and Dominique Bly wrote in a note. In addition, issuers rated CCC remain pressured in aggregate, despite the recent outperformance of their debt, they wrote.

They cited low levels of earnings the companies have in aggregate compared with their interest expense. Borrowing costs for CCC rated firms are still around 10% — crippling for some small companies when they have to refinance following the end of the easy money era — and leaving them at risk of default even as rates fall.

Any weakness in the labor market would also “be a headwind for spreads as it will increase recession fears and lower yields,” JPMorgan Chase & Co. analysts including Eric Beinstein and Nathaniel Rosenbaum wrote in a research note this past week.

To be sure, valuation concerns remain modest and investors are for the most part overweight corporate debt. The beginning of the rate-cutting cycle should also support demand for non-cyclicals over cyclicals in the investment-grade market, analysts at BNP Paribas SA wrote in a note.

In particular, limited issuance by health care firms and utilities provide room for spread compression, they added.

“It’s a prime opportunity for non-cyclicals to outperform,” Meghan Robson, the bank’s head of US credit strategy, said in an interview. “Cyclicals we think are overvalued.”

Week in Review

• Traders are piling into bets on further easing by the US central bank after it cut interest rates on Wednesday by a half percentage point — its first reduction in four years. The historic move ended weeks of speculation about whether the Federal Reserve would kickstart its easing cycle with a quarter- or half-point cut.

  • The cut is supportive of credit spreads overall, but it will encourage corporate bond issuance — particularly from high-yield issuers. The cut will likely favor those borrowing at the front- rather than back-end of the yield curve, according to market participants surveyed by Bloomberg

    • “The Fed delivered a dovish surprise with a hawkish twist,” Noah Wise of Allspring Global Investments told Bloomberg News

  • Credit derivative spreads dipped Wednesday following the move, to around their narrowest since the pandemic

  • However, Fed Governor Michelle Bowman warns that the 50 basis point reduction “could be interpreted as a premature declaration of victory” over inflation

    • Bowman became the first Fed governor to dissent against a rate move since 2005, when she voted against a 50 basis point cut in favor of a 25 basis point cut instead

  • In other central bank news, the Bank of England kept rates unchanged and warned investors it won’t rush to ease monetary policy

• Wall Street banks burned two years ago after backing big corporate buyouts and ending up with tens of billions of dollars of “hung debt” are now back for more, getting ready to underwrite more European LBOs.

• Companies taking advantage of lower financing costs to win better terms on existing debt or to push out maturities have borrowed the most from the US leveraged loan market in seven years.

• Liquidators of China Evergrande Group, the world’s most indebted builder, are returning to a Hong Kong court as they attempt to wind up a subsidiary with key assets.

• UBS Group AG is leading a $1.15 billion financing package to support Vista Equity Partners’ acquisition of software company Jaggaer, beating out direct lenders who were also competing for the deal.

• Apollo Global Management Inc. clinched $5 billion in fresh firepower from BNP Paribas SA as it looks to grow a key lending business, muscling deeper into turf once dominated by banks.

• A much larger share of managers in the $1 trillion US collateralized loan obligation market are able to buy and sell loans more freely than once feared, after a refinancing and resetting surge pushed back the clock on reinvesting limits.

• In the world of private credit, KKR & Co.’s capital markets arm led a financing for USIC Holdings to help repay broadly syndicated debt, while Oak Hill Advisors provided $775 million to support Carlyle Group Inc.’s purchase of Worldpac, and Alegeus Technologies is looking to score about $75 million in interest savings through refinancing the private loan that Vista Equity Partners used to take the company private in 2018.

• Tupperware filed for bankruptcy after a years-long struggle with sales declines and growing competition.

• Bankrupt trucker Yellow Corp. and its hedge fund owners lost a key court ruling over $6.5 billion in debt that pension funds claim the defunct company owes them, likely wiping out most recovery for shareholders.

• Bausch Health Cos. is working with Jefferies Financial Group to explore refinancing some of its debt to aid a long-planned spinoff of its stake in the eye-care company Bausch + Lomb.

On the Move

• BlackRock Inc. is overhauling its private credit business. The firm is setting up a new division, Global Direct Lending, appointing Stephan Caron, head of the European middle-market private debt business, to lead it. Jim Keenan, global head of BlackRock’s private debt business, will leave the firm next year, as will Raj Vig, co-head of US private capital.

• Silver Point Capital has hired Joseph McElwee from Investcorp as head of collateralized loan obligation capital markets and structuring.

• Jefferies Financial Group Inc. has hired former Citigroup Inc. banker Simon Francis in a newly created role leading its debt financing business in Europe, the Middle East and Africa.

• Fidelity Investments has recruited Lendell Thompson, a former director at Vista Credit Partners, as it continues expanding into the private credit market. He will be a managing director in the firm’s direct lending team.

--With assistance from Dan Wilchins and James Crombie.

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